Governance and economic growth: The role of the exchange rate regime

Abstract

In this paper, we revisit the relationship between governance and economic growth focusing on the role of exchange rate regime. The conventional theoretical view is that increased quality of governance stimulates economic growth, while recent years show that some countries with weak governance are experiencing more economic growth. We show that the effect of governance on economic growth is influenced by several factors such as the potential costs associated with choice of the exchange rate regime. We carried out GMM regressions on panel data to overcome heteroscedasticity, autocorrelation and homogeneity problems. Our panel covers the period 1996-2012 and comprises 50 countries, among which 21 are developed and 29 are emerging. We found that governance is not highly significant to explain economic growth while exchange rate flexibility significantly destabilizes emerging markets and accelerates economic growth in developed countries. Likewise, we found that good governance encourages the choice of flexible exchange rate regime and that exchange rate flexibility requires the improvement of governance to stimulate economic growth in emerging countries. Concerning developed countries, good governance accelerates economic growth if the exchange rate regime is not too flexible and exchange rate flexibility increases economic activity if the governance is not of high quality. Thus, our estimates show that the nature of the exchange rate regime plays a crucial role in the decision to improve the quality of governance. Similarly, the quality of governance determines the optimal exchange rate regime. The interaction term between the overall governance index and the degree of exchange flexibility is statistically significant at the conventional threshold, confirming the importance of the theoretical and empirical foundations raised in this research.