The Institutional Determinants of Bilateral Trade Patterns

(roads, ports, electricity, communication channels) and foreign currency markets. The first
two governance indicators are foremost fundamental factors underpinning at a deeper level
the likelihood of good governance.

The next variable is “Government Effectiveness” (Gov. Eff.), a measure for the quality
of government inputs. It represents, amongst others, the perceived quality and
independence of the bureaucracy. This indicates the ability of government to formulate and
implement good policies. It is a determinant of the quality of governance.

The fourth institutional variable is “Regulatory Quality” (Reg. Qual.). It is directly
focused on the quality of implemented policies. It includes the perceived incidence of
policies that inhibit the market mechanism, and excessive regulation of foreign trade and
business development. We can view this variable as directly related to the economic
environment of society. The indicator closely reflects the transaction costs that result from
policy intrusion by the state in private trade.

Regulatory quality and the fifth indicator, “Rule of Law” (Rule of Law), more directly
indicate the quality of governance. Rule of law indicates society’s perceived success in
upholding fair and predictable rules for social and economic interaction. Essentially, it
focuses on the quality of the legal system and the enforceability of contracts.

The last indicator, “Control of Corruption” (Contr. of Corr.), represents the extent of
‘lawless’ or unfair behaviour in public-private interactions. It complements regulatory
quality and rule of law indicators, pointing at the impact of bad governance on economic
interaction. Corruption, like regulatory intrusion, affects transaction costs by adding a
‘third-party’ involvement to private transaction. An added component of corruption to
trading costs is its arbitrary, uncertain nature.

Table 1 below illustrates the data on institutional quality. It presents the sample means
and standard deviations for each of these indicators, together with some tentative
illustration of the corresponding cross-country deviation of institutional quality.

Bilateral Trade Flows and Institutions

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