Seven Questions on How Institutions Shape Financial Markets

• Author: Bernardin Akitoby
• Pages: 6-8

Page 6

Question 1: Can institutions explain why capital does not flow from rich to poor countries?

Recent research provides an affirmative answer to this question. For example, Alfaro, Kalembi-Özcan, and Volos-ovych (2008) empirically investigate the factors behind the lack of capital flows from rich to poor countries, the so-called "Lucas paradox." They argue that during 1970-2008, low institutional quality was the most important factor behind that paradox. The empirical findings suggest that improving Turkey's institutional quality to the U.K.'s level could lead to a 60 percent increase in foreign investment, while improving Peru's to Australia's could quadruple the level of foreign investment. Drawing the policy implication from their study, Alfaro Kalembi-Özcan, and Volosovych conclude that countries aiming to attract capital flows should strengthen protection of property rights, law and order, bureaucratic quality, and government stability.

Question 2: Do institutions shape the pricing of sovereign risk?

The simple answer is that institutions have some independent influence on sovereign spreads beyond the fiscal and economic outcomes they shape. Akitoby and Strat-mann (2009; forthcoming (a) and (b)), using a panel of 32 emerging-market countries during 1994-2003, find that institutions indeed matter for the pricing of sovereign risk. Democracy, regardless of how it is measured—the Kauf-mann voice and accountability index, the Freedom House index of political rights, the Polity index, or the International Country Risk Guide (ICRG) democratic accountability index— was found to be negatively associated with spreads. Specifically, a one standard deviation in the ICRG democratic accountability index reduces spreads by about 25 percent. Stronger civil liberties also exert a negative impact on spreads, as civil liberties foster democracy. These results lend support to the idea that financial markets reward democratic regimes. Put differently, the markets tend to penalize nondemocratic regimes by charging them relatively higher spreads. Since the study shows that more government accountability...