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

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

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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