Institutional distance
and bilateral trade
This review has been informed by a compilation of
completed research on the effects of institutional distance on bilateral trade.
Most economists view the institutional gap as a key ingredient in economic
sustenance. This notion is expressed especially by the belief that good
institutions attract foreign investments and encourage a good flow of resources
while institutions with a poor quality cause friction in the flow of trade. In
2012, Ferr ini observed that the history of a region influences the nature of
its political institutions, which in turn determines the economic success of
the region [20]. Additional empirical pieces of evidence further confirm that
the precedence of institutions over integration and geography results in deep
growth [21], indicating that institutions are key elements in defining the
long-run of cross-regional trade flows.
Economies that have realized this have, in various platforms, opened up
their markets to encourage the flow of business ideas for robust economic
growth; achieving this by making their institutional policies as flexible and
investor-friendly as possible [21].
When looked at from the perspective of bilateral
trade, an institution often has a multi-faceted definition [22]. This vagueness
in the definition stems from the fact that even the concept of good governance,
which defines the quality of an institution, is seen by scholars as
multifaceted [22]. In one view, economists view institutions as the units
responsible for establishing the 'rules of the game' for a particular society or, in the
simplified term as provided by North in 1990- the formal and informal
restrictions that define the nature of political, economic, and social
interactions in a society [22]. Under this first perception, scholars view
'good institutions' as those which establish incentive structures to reduce
uncertainty and build efficiency in bilateral trade [22]. Hence, good
institutions end up promoting economic growth.
On the other end of the multifaceted spectrum, is a more specific shape
to the broad concept of institutions. The definition terms institutions as
particular organizations, entities, regulatory bodies, or procedural devices
that affect the flow of trade by primarily creating and implementing better
policy choices [21]. Regardless of the dual perspective on what really
constitutes institutions, there is a point of consensus on the primary
significance of these institutions. The
consensus is that institutions are different both in how they are run and their
relative impacts; these differences shape the varying levels of productivity
between companies, organizations, and even regions, thereby determining the
trade volumes and the patterns of trade flows. This is a comparative advantage
to the absence of institutions that would cause stagnation due to a balance in
demand and supply of resources across regions.
Shedding more light into this phenomenon, Douglas North expressed that
institutions governing trade are seen as the determinants of demand and supply
[23], which affect exchange relations and dictate the magnitude and direction
of trade between any two countries [20].
A majority of the works of literature which analyze
the impact of institutional distance on the performance of bilateral trade have
focused on the question: Does institutional distance enhance or reduce exports
and imports, and if so, how? [10-17]. This also forms the basis of this
meta-analysis. The prior assumption in the meta-analysis is that the
institutional distance enhances exports more significantly in industries and
countries that are highly institution dependent [22]. This assumption is based on prior work by
Levchencko, which expressed the belief that some economic sectors rely on
institutions more than others [24].
Indeed, there are industries in which 'dependence on institutions' and
the 'enforcement of property and contract rights' are considered as
technological features in the production process. This is partially true
considering the differences in the complexities of goods made by these
industries for trade. Goods can be
standard, very complex, or less complex. The complexities, in turn, influence
the number of intermediate checkpoints that the goods must pass through before
they are ready for trade. Every checkpoint would require contractual agreements
and the implementation of property rights. The complex goods would take more
time because they require a large number of contracts to be generated, a
process that relies more on the quality of contract enforcement policies in
every country [25]. The end game of the property right enforcement and contract
acquisition procedures, therefore, implies that good contract enforcement,
which translates to high institutional quality, becomes a factor of comparative
advantage in production and thus the flow of trade.
In separate work, Badrahan noted that the evident
confusions in international trade that relate to the 'international border
effects' places national borders as a matter of huge significance [22]. The
significance is most apparent when one of the participant countries in a
bilateral trade comes from a rich country. The rich countries tend to mend
their institutional influence to their own economic advantage by using economic
transactions in favour of home companies, entities, or organizations. The
relative political potions of these two countries define the strength of their
institutions, which in turn gets manipulated by the rich countries in their own
favour [26,27]. In particular,
contractual and property right enforcements in poor countries are not highly
effective as it is in rich countries [22]. It could be the primary reason
behind the gaps in border observance when bilateral trade occurs between a rich
and a poor country. The more developed and effective the institutional set-ups
are in any two countries involved in bilateral trade, the higher the chances
that the border rules will be followed appropriately [22].
A more elaborate review of the influence of domestic
institutions on international trade was completed by Moore et al. These authors used a series of facets to show
how domestic institutions are indeed a source of comparative advantage for
bilateral trade. Using historical evidence of intentional trade, Moore et al.
portrayed that any change in the domestic institutions is often supported by
powerful interest from authorities who look to influence the direction of
bilateral trade to their favour [27].
Both the type of trade (whether the trade involves the production and
exchange of institutionally dependent goods or not) and the degree of pressure
put on it by the institutional policies become the key determinates of whether
or not the institutional gap between any two countries enhances growth or
retards growth [22].
Several authors have also come up with different trade
models attempting to explain the impacts brought on trade patters by the
differences in institutional setup. In
2003, Anderson and Marcouuiller showed that the quality of institutions put in
place to protect property rights and to enforcements played a role in the
variations in trade volumes between countries [28]. In particular, these
authors underscored the significance of the contract enforcement regulation
[28], citing it as the key to eliminating the reduction in trade response,
which often occurs as a result of the fears of insecurities hidden in
international exchanges [22-28]. They
developed a model in which constrains of insecurity to trade were depicted to
cause hikes in the price of goods exchanged in bilateral trade. The model proposed that the likelihood of
loss is seen in a price-mark, which is equivalent to a secret tax on trade
[28]. The proposal was supported by empirical evidence, using the gravity model
approach, to illustrate that bilateral trade is highly reliant on the
institutional quality of the trading countries.
In it, better institutions emerged to be causing larger trade volumes
[28]. In the same year, Ranjan and Lee
emphasized that bilateral trade volumes will always be affected more by the
institutional quality only in sectors that have been classified by research as
institutionally intensive [29].
In the year 2004, Levchenko proposed a simple model
regarding contracts and international trade. The model modelled the
institutional difference with reference to incomplete contracts. In it, the
author attempted to reverse prior conclusions that had been arrived at by
simply equating institutions with productivity alone [30]. According to
Levchenko, several other things are realized as a result of institutional
differences, including the reality that underdeveloped economies have a higher
probability of failing to gain from trade [30].
The author validated this model using empirical data. The results proved that countries which have set
up better institutions, thus lesser contract incompleteness, have registered
larger import shares in the United States in the contract-dependent market
sectors [30]. In the model, Levchnecko used the Herfindahl index of
concentration of supplier input for the final producer of a product. The higher the dispersion of the input suppliers,
the higher the chances of contract-dependence, and the more they need for
institutional intensity [31].
Two years later, Nunn constructed a variable to
measure the proportion of intermediate inputs of each good that required any
relation-specific inputs [22]. Nunn's concept borrowed from a completed work in
1999 by Rauch, which classified the inputs into some with an organized
exchange, some with reference price, and others with neither organized exchange
nor any form of the reference price [22]. The variable was inspired by the idea
that selling an input in an organized exchange means that the input is thick
[22], where alternative buyers and sellers are present, such that the value
ascribed to the input outside the limits of a buyer-seller relationship is not
far from that outside the limits of the buyer-seller relationship [22]. Thus,
the input is not necessarily relation-specific. Using this concept, Nunn
computed the contract-dependence against every final good in the trade. He then combined his statistical analysis
with his previous findings on trade flows and the quality of judicial
institutions of a specific country. In so doing, he established that countries,
where there is good institutional contract enforcement, produced relation-specific
goods that are very important in maintaining trade flows [32]. The model
revealed that institutional distance between countries influences more global
trade patterns when compared to the combination of capital and skilled labour.
The case of institutional
distance and china’s belt and road initiative (BRI)
In 2013, President Xi of China, during one of his
visits to Kazakhstan and Indonesia, introduced an initiative to create an
economic link between China and the foreign market. Xi had had the idea of strengthening
China’s global connectivity by combining new and old infrastructural projects
covering an expansive geographic scope [33]. These projects combine hard
infrastructure, soft infrastructure, and cultural relationships [34] in over
138 countries whose combined Gross Domestic Product (GDP) totals to $29
trillion [35], and with up to 4.6 billion economically productive people inside
[36,37]. Xi’s initiative was inspired by the over 2000-year old silk route
constructed by the Han Dynasty for the purposes of trade in ancient China [38].
Goods in Silk Road moved from the East to the west and were transported by
foot, camels, horses, and yaks. At the time, the Chinese merchants explored the
western markets using the Silk Road, and they enabled vital business
affiliations between China and the Western world, mainly through barter trade.
Fast-forward to the 21st Century, the Chinese head of state seeks to modernize
the business ideals of the ancient Han Dynasty by creating trade routes to
traverse Asia and the rest of the world [39]. Despite the similarity in the
ideologies behind their conceptions, it is important to note that this
modern-day initiative is quite the contrast, if not a highly advanced
development, of the ancient Silk Road [39]. The ancient Silk Road was founded
on an agricultural society, covering Asia and Eurasia for commodity export and
entrepot trade [39]. In contrast, the modernized trade routes are founded on
robust industrialization, advancement in technology, and economic
globalization, covering the entire globe for both commodity and capital export
by means of direct trade [39], [37].
Now, the Silk Road economic belt and the 21st century Maritime Silk Road
is known as the Belt Road Initiative (BRI) [39].
BRI is rapidly developing, and as of April 2019, the
project had attracted up to 125 signatures of cooperation from country
representatives across the globe [36], which jointly constitutes more than 70%
of the world’s population, 30% of the world’s GDP, and 24% of the global
household consumption [40]. Despite a host of competing actors who discredit
the project for its lack of criteria on what qualifies and what does not
qualify as BRI, a successful realization of the strategies of the BRI would
place China at the centre of the global economic affairs [41].
The initiative is seen to have come at a prime stage
when the global economy is undergoing gradual recovery from the frequent
recessions of the previous decades. Yet, the rate of this economic development
is not uniform because while some countries are at the take-off stage, some are
experiencing a drive to maturity, and others such as the United States of
America are one foot into the age of mass consumption [42]. With this
realization, China perceives that BRI can be taken as a common point for
cross-country cooperation towards a uniform global economic growth [42]. The
initiative further provides Chinese enterprises with the opportunities to open
up to other countries through trade. In
a recap, by the end of the year 2015, just two years after the start of the
BRI, Chinese companies were making direct investments to over 50 countries
through this initiative, with transaction amounts totalling to $18 billion by
the end of that year [41]. The flow of
investments through this very initiative has been on the rise at a 38.6% rate
year-on-year, a rate twice that of the growth towards the world [43]. In the
same year, the total of direct investments coming from China into the BRI added
up to $ 115.68 billion, a value which approximated to 10.5% of the Chinese
overall direct investment stock in 2015 [42]. These statistics reveal that the
BRI had already become a new facilitator of the rapid growth of China's foreign
direct investments, even at its preliminary stages [40].
At present, there is evidence of achievements,
especially in the cooperation of infrastructure between China and some of the
interested countries. Nonetheless, a majority of the Chinese foreign
investments have so far been directed towards the South East Asian
nationalities and neighbouring Russia only [44,45], creating an imbalance in
the realization of the BRI goals. This imbalance in investments under BRI may
be interpreted as China's attempt to secure a strong local base in the Eastern
Region before it can advance outwards to venture in the western markets
[46,47]. However, experts argue that the imbalance is a consequence of
defaulters of the BRI who have opted to repackage their support for the program
for fear of investment uncertainties [48]. The factor of complicated security
is, by far, the greatest determinant of such reduced cooperation and skepticism
between the investors from the western world and China [48]. These security
concerns emanate from the fear of cultural conflicts, different powers styles,
and religious influences on trade- all of which place further risks on future
cooperation in the direct foreign investments [49].
Regardless of the backlog of uncertainties surrounding
the full implementation of the BRI, economists forecast that the beneficiary
countries of the BRI are most likely to benefit from the initiative due to the
provision of hard infrastructure. Take, for instance, the prediction by the
Asian Development Bank (ADB). The bank has estimated that developing nations
from the East Asian Region collectively need up to $26 trillion for effective
infrastructural developments that will sustain their competitive economic
growth in the global environment. China has made its presence known in the
scenario by pledging up to $1 trillion in aid of these infrastructural
developments. If China triggers these financial dealings, then it will garner
considerable political control against the economic strength of these South
Eastern Countries. It is worth noting that a majority of the regions which are
targeted by the BRI are struggling with underinvestment as a result of weaker
domestic GDP. Countries such as Myanmar and Pakistan would be perfect examples
in this case due to their low rankings in the United Nations Human Development
Index (HDI). Myanmar ranks 148th, and Pakistan ranks 150th in the global HDI
rankings. It only makes sense to experts that these two countries are heavily
targeted by the BRI against their economic strengths.
On the surface, BRI appears as a normal investment
assortment seeking to eliminate trade frictions such as tariffs and transport
costs. It is readily conceivable that the development of better hard
infrastructure with neighbouring states reduces transport costs and transport
times. It is also evident that the establishment of soft infrastructure will
expand the range of goods to be traded due to reduced trade restrictions. The resulting overland economic connectivity
will boost growth in China because China has a huge reserve of savings that are
not currently being put in constructive use. Making large-scale investments
overseas using this amount of money, especially in financing infrastructural
projects, gives China the opportunity to export its financial largesse and
enable its state-owned enterprises to work on the international front. These
and other outward implications of the BRI are explicitly acknowledged in
China's official BRI proposal [50-56].
However, the impact of the BRI on foreign institutions
are less publicly articulated. China's economy has slowed down, and most of its
state-owned enterprises have nearly exhausted the provisions of the once
booming economy. As a consequence, a majority of its construction, cement, and
steel companies are faced with a struggle to gain grounds in the international
markets due to the differences in institutional regulations on the
international markets. The BRI thus comes as an alternative to eliminate this
institutional distance between China and the foreign destinations so that it
can create a room of operation for its state-owned companies on a global scale.
As China injects its surplus savings into financing international projects, the
targeted countries around Eurasia slowly become dependent on China's economy.
This scenario gives China economic leverage over these foreign economies, thereby
empowering China to make changes to, shape, and interfere with the rules and
norms that govern foreign institutions with regard to economic affairs. In so
doing, China stands a chance of making both economic and political gains by
taking control of the institutional distance between its domestic market and
the foreign markets. This is not to say that partner countries fail to reap
concrete benefits from the BRI, rather, a critical outlook on how China is
exploiting its BRI strategies to override the barriers of institutional
distance on trade.
It would enable China's state-owned companies to
outbid foreign companies from financially constrained countries in projects
that attract highly competitive international biddings. An evident case involved the Japanese
construction firms' losses to their counterparts from China in their bids to
steer the Indonesian high-speed rail project. Critically, it can be concluded
that China is using its financial dominance to reduce the institutional
distance between its local environment and the neighbouring counties in order
to increase its returns on foreign direct investments. This was practically evident in Indonesian's
response to the questions over their rationale for awarding the construction
contracts. The Indonesian government accentuated that the previous financing
from China had placed China in favour to edge out competitors in subsequent
competitive platforms for development.
The evaluation of the ongoing BRI constructions
further reveals the extent to which China has monopolized the foreign
institutions in South East Asia through the BRI initiative. The implementation
of the China-Pakistan Economic Corridor (CPEC) is already underway, and it has
been fraught with disagreements. The CPEC project was proposed by China in a
bilateral meeting of the three heads of states (China and Pakistan) held in
2013. The corridor extends over a 3000
km stretch of land to connect Kashgar in China and Gwadar in Pakistan. The flagship project under BRI compounds a
trade network of optical cables, railways, highways, and pipelines that connect
the Silk Road Economic Belt towards the North and the 21-st Century Maritime
Silk Road in the South. Both China and Pakistan view this project as critically
significant in their economies, except for their different viewpoints. China
does not seem dependent on the project, unlike Pakistan, which is too devoted
to let it pass. In fact, a recent slowdown of the projects under CPEC in the
aftermath of slight geopolitical tensions pushed the Pakistani Prime Minister
to make controversial steps just to ensure the progression of the project. The
Prime Minister went ahead to exempt a state-owned Chinese company operating at
Pakistan's Gwadar port from taxation just to push forward for the continued
construction of the CPEC projects. These and other scenarios have been used to
prove that BRI is slowly giving China political gains in foreign destinations.
Through these gains, it is reducing the influence of the normative regulations
of the foreign institutions, thereby reducing institutional distance as a means
for maximizing economic growth.
Reliable sources confirm that the international
recipients of China's proposal are already fully aware of the significance of
institutional distance. Weighing from their responses so far, the international
environment has measured the implications of BRI on the institutional gap with
China and are skeptical about fully implementing it. Countries such as Myanmar,
Australia, and India have hard lukewarm cooperation with the BRI as a show of
distrust of China's motives. Australia
was reluctant to allow specific investments spearheaded by Chinese state-owned
companies by rejecting calls to align its domestic infrastructure budget with
the BRI formally. Canberra declined two bids by China's state-owned enterprises
in Canberra's energy and agricultural sectors by claiming that China was
infringing on its matters of national interest and security concerns. Similar
claims were aired by Myanmar, which is currently cooling down on its earlier
enthusiasm for working with China. Myanmar had vigorously entered into
investment deals that made China the largest investor in Myanmar. Having
noticed the growing influence of Chinese companies in the country, Myanmar is
slowly reconsidering its steps and has since halted the construction of the
Myitsone Dam, which is among the most significant Chinese investment in the
country. Similarly, Indian leaders missed on the 2017 and 2019 Belt and Road
Forums and have further expressed disinterest in the passing of CPEC through
Kashmir.
Empirical data suggest the sensitivity of
international trade to political restrictions, strengths of the currency, and
raw materials. Likewise, international companies have been linked to increased
competition and the continued flow of surplus goods- all of which are
significant contributors to economic recovery and growth. Therefore, the
analysis of the current empirical evidence connecting international trade and
the institutional distance, along with the elaborations on potential
moderators, may be particularly relevant in cautioning the international
audience on their support for the BRI.
To address these issues, this meta-analysis compounds
several works of the literature investigating the association between bilateral
trade, Belt and Road Initiative, and the institutional distance. Specifically,
the meta-analysis addresses the following questions: What is the overall
magnitude of the association of institutional distance with bilateral trade and
BRI? Do structural as opposed to functional aspects of institutional distance
differentially impact international trade? Is the association moderated by the
participant country's characteristics (GDP, HDI, political stability, natural
resources) or by study characteristics (duration of the study, the inclusion of
statistical controls)? The
methodological approaches used are versions of meta-regression models. The
models create a relationship between the bilateral export performance and the
economic sizes of the importing and exporting countries as well as their
existing trade costs. The outcome of the
meta-regression models indicates that institutional distance is a determinant
of international trade, more significantly impacting the
institutionally-dependent items of trade.
These results emphasize the need for institutional reforms that may
boost the capacity of developing countries to add higher value to their economy
by means of international trade.