In general, the impact of a higher perceived quality of governance on bilateral trade is
positive and highly statistically significant, independent of which indicator of quality is
used in the analysis. Because the indicators of institutional quality vary between
approximately -2.5 to +2.5, we cannot log-linearize the relation between institutions and
trade. The relation necessarily is of a semi-log form. The effect sizes reported are semi-
elasticities. To interpret the substantive impact suggested by these effect sizes, we start
from the standard deviation of these variables within the sample. The effect on trade of a
difference of one standard deviation from the average institutional quality gives a good
picture of the contribution to the empirical explanation of the variation in trade flows. Table
1 in Section 3 presents the sample means and standard deviations of the indicators for
institutional quality, as well as some illustration of the cross-country spread in the quality
of governance.
Although differing between indicators and according to the country’s role as exporter or
importer, the impact of variation in the quality of institutions on trade is substantial. An
increase in regulatory quality of one standard deviation from the mean leads to an estimated
increase of 20 to 24% in trade. Lower corruption, on average, accounts for 17 to 27% extra
trade.10
The effect of similarity in institutional quality, presented in the last row of Table 3, is
less significant statistically. Still, the impact can be substantial. To this effect, we find that
having a similar law or regulatory framework promotes bilateral trade by 12% to 18%.
Institutional homogeneity leads to familiarity with each others formal procedures, and with
the informal conventions and habits developed to deal with the governance situation. As a
result, the competences of potential trading partners match better. This arguably reduces
uncertainty surrounding transaction contingencies, and reduces the adjustment costs that
have to be made because of natural unfamiliarity with international trading partners. Also,
similarity of informal business procedures may increase bilateral trust. As a result,
economic agents get more confidence in being compatible trading partners, compared to the
situation of two institutionally heterogeneous countries. The effect of common institutional
quality seems not present for the indicators based on corruption and government
effectiveness. This is not so surprising, since government effectiveness is not a direct
measure of the quality of governance. As a result, the link from a common score on
13
Bilateral Trade Flows and Institutions