Institutional Quality, Trade and Growth

Abstract

Acknowledging the benefits historically attributed to national competitiveness due to institutional quality and economic development, it is justifiable to point out that there is a robust relationship between institutional quality, economic growth, and trade development. At present, Brazil and South Africa have risen to a point where they have become not only influential in the regional and global economy but also significant influencers in global politics. Despite being a relatively new nation in terms of independence, South Africa has a strong impact on the security and economic development of the Southern African region. On the other hand, Brazil’s rapid economic growth, integration politics, and foreign policy have ascended the country to a regional power in Latin America. The purpose of this term paper is to explore the impact of institutional quality on the trade and economic growth of the world’s leading economies: Brazil, Russia, India, China, and South Africa (BRICS). The research employs the document analysis approach as a qualitative research method used to triangulate data from various scholarly resources, reports, and government websites. Research shows that better institutional quality and governance foster financial development in emerging economies, whereas trade openness and economic growth are the primary determinants of financial depth in emerging economies.

Keywords: Institutional quality, Trade, Economic Growth, Emerging Economies, Brazil, South Africa, China, Russia, India, BRICS

Financial Development

Introduction

Interest in the relationship between institutional quality and financial development is evident across various researches. A similar trend is apparent in studies that seek to establish the connection between the level of financial development and trade and economic growth. Observably, these inquiries are inclined to developing economies based on the presumption that exports from these economies are positively influenced by political stability, effective governance, the level of maturity in the legal system, and control of corruption (Jadhav, 2012). The same effect is hypothesized to be similar in emerging economies, which are marked by higher volume import and export trade than developing economies. The BRICS economies have risen to the position of pivotal actors not only in the global economy but also in global politics. Consistent with Kappel (2010), these economies have become regional powers. In Asia, China and India stand out as regional power. South Africa (Africa), Brazil (Latin America), and Russia (Europe) have also ascended to the point where they have a significant influence on global politics and the global economy. The unique location and influence of Brail and South Africa make them a subject of interest in this analysis. For this reason, the research will focus more on Brazil and South Africa. Inward foreign direct investment (FDI) in emerging economies is largely determined by the improved level of infrastructural development, institutional quality, and the adoption of advanced technologies. The purpose of this term paper is to explore the determinants of financial development in the world’s leading emerging economies: Brazil, Russia, India, China, and South Africa (BRICS) with a focus on institutional quality, economic growth, and trade openness.

Literature Review

Brazil is increasingly gaining influence in South America and the global economy due to its rapid rate of growth, integration politics, and foreign policy. On the other hand, despite being a much new and small country, South Africa is pivotal to the Southern African region because of the formation of security architecture, the fiscal integration in the Southern African Customs Union (SACU), and the integration of the Southern Africa Development Community (Kappel, 2010). The attention to the relationships between institutional quality, trade openness, and economic growth in emerging economies, including Brazil and South Africa, is evident across an array of economic researches. Empirical and qualitative evidence from a range of studies points out that there is a relationship between regional power, economic growth, and trade openness via institutional quality through, for example, improved governance and control of corruption (Akpan, Isihak, & Asongu, 2014; Doyle & Martinez-Zarzoso, 2011). Jadhav (2012) investigated the role of institutional, economic, and political factors in attracting foreign direct investment (FDI) in BRICS economies. The study employed panel data for a 10-year duration (2000-2009) to explore the significant determinants of FDI in these economies comprehensively. The study considered natural resources, trade openness, and market size as economic determinants. In the same context, it took into account inflation rale, regulatory quality, political stability, as well as control of corruption, accountability, and freedom of the press as political and institutional determinants of FDI. According to Jadhav (2012), these factors were drawn from the previous empirical literature. An empirical analysis of the research data showed that trade openness, accountability, voice, and rule of law were statistically significant, implying that these variables have a considerable positive effect on total foreign direct investment. An understanding of the connection between institutional quality, trade, and economic growth in emerging economies can be achieved by reviewing the literature on the highlighted determinants, with a focus on Brazil and South Africa.

Institutional Quality

Grounded in the panel data analysis covering 164 countries (1996-2006), Buchanan, Le, and Rishi (2012) investigated the relationship between institutional quality and FDI levels and FDI volatility. The researchers concluded that good institutional quality is pivotal to foreign direct investment. Buchanan, Le, and Rishi (2012) quantitatively illustrated that institutional quality has a significant and positive effect on inward FDI. The same study revealed that institutional quality is significantly and negatively associated with foreign direct investment volatility, which has a detrimental effect on economic growth. In other words, institutional quality fosters inwards FDI, which in turn improves economic development. The results suggested that FDI volatility has a detrimental effect resulting in lowering economic growth; hence, a country can effectively attract FDI and induce economic growth by creating an attractive macroeconomic environment alongside institutional reforms (Buchanan, Le, & Rishi, 2012).

Economic Growth and Trade Openness

Doyle and Martinez-Zarzoso (2011) conducted a panel analysis of countries regarding the relationship between institutional quality, trade, and productivity. The analysis covered the duration of two decades (1980-2000). The researchers used both nominal and real openness as a metric of trade. In the same line, various statistical instruments were utilized to account for institutional quality and the endogeneity of trade (Doyle & Martinez-Zarzoso, 2011). From the research results, Doyle and Martinez-Zarzoso (2011) concluded that there is a strong connection between trade openness and labor productivity. These determinants translate into financial development and economic growth. In other words, countries that trade more, including exports and imports, tend to generate a high level of productivity, thus supporting the theory that growth is catalyzed by the institutional quality. In fact, trade openness makes a country more attractive or competitive in the global economy. Consequentially, the economy grows due to improved foreign direct investment.

Foreign Direct Investment (FDI)

Foreign direct investment is widely documented as a major precursor to economic development and growth and development (Alrezaki, 2009; Kolstad & Villanger, 2008; Volberda, et al., 2011). In real terms, the flow of capital across the national border of emerging economies has been increasing significantly for the past decade. While it is indisputable that the benefits of FDI are significant to economic development, the benefits are considered to be induced by various determinants of FDI. Akpan, Isihak, and Asongu (2014) employed a panel analysis using eleven years’ data (2001-2011) to explore the determinants of FDI in Mexico, Indonesia, Nigeria, and Turkey (MINT) as well as the BRICS economies. The study results showed that trade openness, market size, and infrastructure availability played a critical role in attracting foreign direct investment to MINT and BRICS economies. In the same context, it was noted that the role of natural resources was insignificant in the same economies.

Voice and Accountability

Alongside violence and political stability, voice and accountability are the indicators of the impact of governance in a country (Das, 2015). Gender-sensitive and economic freedom budget initiatives in Brazil and South Africa are increasingly making a significant contribution to the improvement of the socio-political and economic environment of these nations. National budgets are approved by the legislature, thereby authorizing governments to raise revenues, affect expenditures, and incur debts to achieve certain national goals. Given that budges determine the source and application of national financial resources, they play a critical role in governance and the fulfillment of social, legal, political, and economic goals. The good institutional quality provided guidance for the identification of methodologies, partners, and entry points, which can help developing economies strengthen accountability, voice, and the responsiveness of the marginalized groups of the society in budget and economic policy processes.

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

Regulatory quality, (RQ), rule of law (RL), corruption control (CC), and governance effectiveness (GE) are principal components of governance, which have a significant impact on the capital accumulation and economic development of a country (Das, 2015). According to Das (2015), the crisis in developing countries in Asia, Latin America, and Africa reveal that corruption and poor legal systems are detrimental to their trade and economic development. These components of governance improve the competitiveness of a country for foreign investors. The logic is that they are considered free from corruption, as well as based on accountability, transparency, competitive bidding, and constitutionalism, thus being more attractive than those identifiable by rampant corruption and unwarranted bureaucracy. Systematic corruption is detrimental not only to trade but also to the economic development and growth of a country because it limits the flow of inward FDI. By exploring the causes and impact of corruption, poor governance, and poor regulations, it becomes apparent that these governance variables have a significant impact on trade openness and economic development. One of the major challenges limiting the trade and economic growth of Brazil is rampant corruption (Roberts, Schreiber, & Scissors., 2012). In fact, corruption in Brazil also exerts a negative impact on the confidence of investors regarding judicial freedom as influenced by executives and politicians.

Economic Freedom and Technology

Grounded in the traditional notion that economic freedom has a positive effect on the economic empowerment of citizens and the development of an economy, it is justifiable to point out that economic freedom (EF) has a direct relationship with foreign direct investment. The logic is that dependence on economic freedom eases inward FDI flows into a country as it minimizes uncertainties, deadweight losses, and ineffectuality. Haydarolu (2016) explored the interaction between FDI, economic freedom, and economic growth in the BRICS economies over the period ranging between 1995 and 2013. The examination of the data gathered during this period employed panel data analysis. The results indicated that the index of economic freedom is positively related to economic growth. In addition, the results revealed that economic freedom is a statistically significant contributor to economic development in the BRICS. Furthermore, the research findings showed that both economic freedom and foreign direct investment have considerable influence on the economic growth of emerging economies. Lack of economic freedom can be indicative of various ways a government can take away the potential profits of cross border trade, thus being a hurdle to FDI. For example, restraining trade policies may discourage MNCs by restricting their ability to import raw material or inputs for manufacturers, thereby increasing their transaction costs and lowering the productive efficiency of multinational corporations in the host country. Similarly, some economic freedom variables in foreign markets, including business freedom, financial freedom, and trade freedom, which amount to the freedom of operating globally, are likely to foster more outward FDI. In other words, economic freedom is a competitive advantage that makes some markets more attractive than others. For example, Brazil is constantly introducing various reforms to remain a competitive destination by improving economic freedom (Roberts, Schreiber, & Scissors., 2012).

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Opportunities and Challenges

Inward FDI has the potential of benefiting both the host government and multinational corporations investing in these emerging economies through FDI (Das, 2015). However, the challenge is to create and sustain national competitiveness, which determines the level of inward FDI (Akpan, Isihak, & Asongu, 2014). Therefore, to promote sustainable economic growth, the governments of BRICS and developing countries across the globe need to create a political, social, and economic environment that absorbs technology spillovers and substantial skills from inward FDI (Ouyang & Fu, 2012). Sustainable economic growth can be achieved by increasing investment in human capital, green technologies, and infrastructure, including roads, railways, energy utilities, and telecommunications (ElMaraghy, 2012). As for most developing countries, there must be a political will to transform institutions, improve economic freedom, and ensure that there are effective foreign policies to enhance international relations in the political, social, and economic aspects of life. Democracy and equality are pivotal for the sociopolitical development and economic growth of developing economies, especially in Africa, which is often associated with food insecurity, corruption, poor infrastructure, political intolerance, and internal conflicts (Sasson, 2012; Schmidt, 2013). According to Roberts, Schreiber, and Scissors (2012), when corruption is high, the judicial system is vulnerable to political interference and private property. The level of corruption in Brazil, for example, is detrimental to the country’s economic development and growth. Some of the most prevalent barriers that should be addressed to improve entrepreneurial activities and FDI in the emerging economies include flaws in the financing, government-induced rigidities in the labor market, inefficient regulation, and burdensome taxes (Roberts, Schreiber, & Scissors., 2012).

Discussion

Both Jadhav (2012), and Akpan, Isihak, and Asongu (2014) empirically demonstrated that institutional quality, including the rule of law and trade openness, have a positive effect on the inward flow of foreign direct investment in the BRICS economies. In furthering this observation, Buchanan, Le, and Rishi (2012) illustrated that institutional quality has a positive impact on FDI, which in turn improves economic growth. Logically, inward FDI is a result of national competitiveness. In other words, FDI is an outcome of increased investment from foreign entities or international trade. One of the important lessons learned from the 2008/2009 financial crisis is the impact of institutional weaknesses on the trade and economic growth of the countries that rely on the inward FDI from the countries within a global village. In other words, the crisis unveiled the institutional weaknesses that had been masked by the precious commodity and credit booms.

It is apparent that good institutional quality is pivotal to FDI and economic growth. For instance, the great maturity of the legal system in a country is an important aspect of good institutional quality, which improves the attractiveness of a country to foreign investments. That is to say, strict adherence to the rule of law induces confidence in both local and foreign investors because they are certain that initiating and operating businesses in the host economy will protect their investments from legal risks. This assertion is consistent with the fact that the principal components of governance, including governance effectiveness, control of corruption, rule of law, and regulatory quality, produce a significant impact on the attractiveness of a country’s trading environment, which influences inward FDI and the resultant economic growth. Given that the foreign direct investment inflow to any country has the potential of being beneficial to the host government and the investing entities, the main challenge is for these economies is to sustain the desired level of inward FDI, as well as ensure that the FDI inflow results in socio-economic transformation and economic growth. To sustain a desirable level of the economic inward FDI, governments of the BRICS economies and other developing economies need to create and maintain national competitiveness, thus becoming attractive for investments from foreign entities, including transnational and multinational corporations (Volberda, et al., 2011). Consequently, Brazil, South Africa, and other emerging economies need more economic freedom. Additionally, respective governments should strive to eliminate barriers to FDI and overall entrepreneurial activity.

Conclusion

The literature review and discussion of the findings above have established that institutional quality, infrastructural development, the adoption of advanced technologies, and inward FDI are vital for the economic development and growth of emerging economies. Given that institutional quality improves a country’s global competitiveness, which in turn fosters trade (FDI) and catalyzes economic growth, formulating and adopting policies that promote institutional quality and national competitiveness demands an understanding of the determinants of FDI improvement. That is to say, governments must analyze their national competitive advantages to exploit the opportunities available in the global economy, as well as curtail the challenges limiting inward FDI. As highlighted in the above review of the literature and the discussion, governments have to improve institutional quality and inward foreign direct investment by investing in infrastructure and ensuring the enhancement of the principal components of governance, including control of corruption, rule of law, governance and regulatory effectiveness. In the same light, governments need to create a healthy social, political, and economic environment that absorbs expertise and technology spillovers from inward FDI. In this regard, emerging economies will sustain their trade openness and economic growth. Concluding, there is a strong connection between institutional quality, trade openness, and economic growth. Therefore, the determinant of foreign direct investment, which is central to this relationship, should be strongly supported to sustain economic development.