Q&A: Seven Questions about the Relationship between Country Finance and Governance

Author:Amadou N.R. Sy - Mariama Sow
Pages:7-10
SUMMARY

Economists have studied the relationship between the quality of institutions and growth extensively (North 1990). In contrast, the relationship between the quality of institutions and financial flows has been studied less. Because low-income countries depend heavily on external financing flows and are trying to strengthen domestic revenue mobilization, it is useful to look at the relationship... (see full summary)

 
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December 2016
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Seven Questions about the Relationship between
Country Finance and Governance
Amadou N.R. Sy and Mariama Sow, Africa Growth Initiative, Brookings Institution
Economists have studied
the relationship between
the quality of institutions
and growth extensively
(North 1990). In contrast,
the relationship between
the quality of institu-
tions and financial f lows has been studied less. Be cause
low-income countries de pend heavily on external financing
flows and are tr ying to strengthen domestic revenue mobili-
zation, it is usef ul to look at the relationship between good
governance and financ ial flows—in particular foreign direct
investment, off icial development assistance, and ta x revenue.
Question 1. Why is it important to assess the relationship
between country finance and governance?
e Addis Ababa Action Agenda identies n ancing for
development, including domestic revenue mobilization, a s
central to achiev ing the United Nations sustainable develop-
ment goals (SDGs) (UN 2015). At the same time, t he process
leading to the development of the SDGs has emphasiz ed
good governance as a priority. One of the SDGs (Goal 16) is
dedicated solely to the “[promotion] of peaceful and inclu-
sive societies for sustaina ble development, [the provision] of
access to justice for all a nd [building] eective, accounta ble
and inclusive institutions at a ll levels.” Bridging the gap and
establishing t he relationship between these two global priori-
ties—nancing for development and good governance —could
yield useful pol icy recommendations for low-income and
donor countri es.
Question 2. How is good governance defined
and measured?
Although it is widely use d and promoted, stakeholders
interpret “good governance” dierently. e IMF denes
it as “the management of government in a manner t hat is
essentially f ree of abuse and corruption, and with due regard
for the rule of law.” When it comes to governance indica-
tors, however, the World Bank World Governance Indica-
tors (WGIs) have been used extensively in empirical studies ,
and their advantages a nd limitations are well documented
(Kaufmann, Kr aay, and Mastruzz i 2010).
The six WGIs reflect t hree aspects of governance. The
first is the proces s by which governments are selected,
monitored, and replaced, which is capt ured by voice
and accountability and political stability indic ators. The
second aspect is the capac ity of government to effec-
tively formulate sound policies, measu red by govern-
ment effectiveness and regulatory quality ind icators. The
third aspect is t he respect of citizens and the state for
the institutions t hat govern their economic and socia l
interactions, which are proxied by r ule of law and control
of corruption indicator s.
A possible limitation of the WGIs is that the y are per-
ception-based measures of governance. A 2 009 paper by
Benjamin Olken stud ies the accuracy of perception-based
indices by comparing t he perception of corruption with an
objective measure of “missing ex penditures” in relation to a
road-building project in Indonesia. e aut hor nds a posi-
tive correlation between perceived corr uption and missing
expenditures. St ill, the author warns against u sing the two
measures interchangeably.
However, Kaufmann, Kraay, and Mastru zzi (2010)
argue that perception is i mportant because it is the basis
for action. For example, if investors perceive a countr y
to be corrupt, they mig ht refrain from investing there.
us, a qualitative percept ion of governance could result
in actual loss es. In addition, there are a few alternatives to
perception indicators. For insta nce, as Kaufmann, Kraay,
and Mastruz zi (2010) point out, corruption, by denition,
does not leave a paper trail and ca nnot be assessed solely
through objective means.
Question 3. Is there reverse causality?
When studying t he relationship between governance and
nancial ows, it is i mportant to control for reverse causality.
Better governance may have an eect on  nancial ows, but
nancial ows may als o have an impact on governance. Most
studies follow Acemoglu, Johnson, and Robinson (2001) and
use settler morta lity as an instru ment to gauge governance.
e authors argue that the qua lity of current institutions
is highly correlated w ith European colonizers’ mortalit y.
Q&A
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