The Institutional Determinants of Bilateral Trade Patterns

Abstract

This paper studies the effect of institutions on trade flows, using a gravity model approach. We start from a standard gravity equation that incorporates geographical proximity, language, trade policy and common history. These factors reflect the costs of trade across geographical and cultural distance. The quality of governance and the extent of familiarity with the resulting framework of rules and norms may also affect the costs of doing business between any pair of countries. This paper extends the gravity equation to include proxies for institutional quality and institutional homogeneity between trade partners. For this, we use indicators on political stability, regulatory quality, and other proxies that reflect the quality of governance. We test whether institutional homogeneity and institutional quality have an independent impact on the trade volume between pairs of countries. We find that having a similar law or regulatory framework promotes bilateral trade by 12-18%. Furthermore, a better quality of formal institutions tends to coincide with more trade. An increase in regulatory quality of one standard deviation from the mean leads to an estimated increase of 20-24% in bilateral trade. Lower corruption similarly accounts for 17-27% extra trade.