CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

According to North (1991), institutions are the humanly devised constraints that structure and control political, economic and social interactions amongst various economic agents. They consist of both informal constraints (sanctions, taboos, customs, traditions and codes of conduct); and formal rules (constitutions, laws, property rights). They are a set of economic, political and social factors, rules, beliefs, values and organizations that jointly motivate regularity in individual and social behaviour (Greif, 2006). They are of three types viz; economic, political and social. Economic institutions are essential for economic growth in any country due to their influence in shaping incentives for various economic actors in a society. They do not only determine the level of economic growth potential of a country, they also determine the distribution of resources and economic gains in the country. Political institutions, on the other hand, deal with the way the political structure in a country influences the behaviour of agents especially with regards to the distribution of political power - de jure and de facto (North, 1991; Acemoglu and Robinson, 2008; IMF, 2005). Institutions have been crafted by man to create a peaceful habitation and reduce uncertainty in the exchange of values. It is also believed that they play key roles in the management of economies in recent years. This is due to the fact that, it is becoming increasingly clear that those involved in economic transactions are not only influenced by economic variables (especially price) but also by a host of other factors that can be classified as institutions (Natal, 2001).

Economic growth is a sustained expansion of production possibilities measured as the increase in real Gross Domestic Product (GDP) over a given period of time (Parkin, Powell and Matthews, 2008). The role of trade in economic growth and

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development is significant. The Classical and Neo-classical economists attached so much importance to international trade in a country’s development that they regarded it as an ‘engine of growth’. International trade increases savings and investment, reduces unemployment and under-employment, enhances greater backward and forward linkages in the economy and ensures a larger inflow of factor inputs into the economy and outflow of goods and services. Trade liberalization, has been defined as a move towards freer trade through the reduction of tariff and other barriers and is generally perceived as the major driving force behind globalization (Wacziarg and Welch, 2008).

The Neo-classical economists believed that the economic growth of a country depends on the level of investment (Solow, 1956). Other scholars brought the concept of endogenous growth into the debate (Lucas, 1988; Romer, 1986). This was made more popular in the work of Mankiw, Romer and Weil (1992) that made human capital relevant to economic growth. Both the classical economists and the endogenous growth theorists seem to assume the institutions in countries affect economic activities. However, the insufficient benefits that accrue to developing countries from the global world suggest that there is more to economic growth and trade than implied by the neo-classical economists (Ige, 2007; Umo, 2001; Garba, 2003).

The issue of whether trade and increased openness of trade would lead to higher rates of economic growth is an age-old debate between pro-traders and anti-traders over the years. Pro-traders of free trade have lauded the gains from trade through the specialization of countries in the production of goods in which they have comparative advantage and engage in trade and exchange to meet their other needs. But the anti-traders see free trade to be the main cause of dumping of goods that have affected the developing countries adversely. New development theorists contend that openness to trade stimulates technological change by

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increasing domestic rivalry and competition, leading to increased innovation; and that trade liberalization by allowing new goods to flow freely across national borders increases the stock of knowledge for technological innovations which spur growth (Ahmed and Sattar, 2004).

Countries in Sub-Saharan Africa (SSA) have implemented a series of economic reforms, including trade liberalization, with the aim of enhancing economic growth. The theoretical basis for these reforms is that trade liberalization is expected to increase trade, thereby increasing investment which in turn raises the rate of economic growth. However, the empirical evidence from the large and growing literature on trade and growth remains mixed. Edwards (1998), Rodriguez and Rodrik (2001) suggest that trade liberalization is not associated with growth; while Baliamoune (2002) and Yanikaya (2003) conclude that trade openness may even retard growth. For instance, while Sachs and Warner (1997) argued that trade openness increases the speed of convergence; the evidence from the study by Baliamoune (2002) suggested that increased openness to trade has led to income divergence rather than convergence in SSA countries. In fact, Rodrik (2001) argues that regarding trade openness and growth, “the only systematic relationship is that countries dismantle trade restrictions as they get richer”.

There is a vast body of literature (North, 1991; Dollar and Kraay, 2003; Baliamoune-Lutz and Ndikumana, 2007; Flaig and Rottman, 2007; Kagochi, Tackie and Thompson, 2007; Siba, 2008; Mwaba, 2000; Gamberoni, von Uexkull and Weber, 2010; Bhattacharyya, 2011) which shows that trade and institutions have both positive and negative contributions to economic growth. Institutions can reduce or increase transaction costs because they determine the nature of exchange. They form a link for connecting the past with the present and the future

-    a kind of path dependency. Institutions provide the incentive structure of any

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economy because they create the structure that shapes the direction of economic change towards economic growth, stagnation, or decline. Therefore, trade liberalization and institutions enable exchange of goods to take place and results in economic growth. On the contrary, economic growth can also lead to trade openness and good institutional framework from the fact that when a country is experiencing growth, this growth would result in increased domestic and foreign rivalry and competition as well as increased institutional innovation.

It has been observed empirically that one of the causes of the limited growth effects of trade liberalization is the weakness of institutions. Indeed, one strand of the literature on growth has argued for the predominance of institutions in economic growth (Easterly and Levine, 1997; Dollar and Kraay, 2003; Rodrik, Subramanian and Trebbi, 2004). Findings from empirical studies have concluded that institutions are crucial for the success of economic reforms in developing countries (Acemoglu, Johnson and Robinson, 2003; Dollar and Kraay, 2003; Addison and Baliamoune-Lutz, 2006). The evidence suggests that the failure of trade reforms to promote trade and growth in SSA countries is attributable to the poor quality of institutions. In a study by Addison and Baliamoune-Lutz (2006) on North African countries, the results of the study show that the growth effects of economic reforms depend to a large extent on the quality of institutions.

It is in the light of the above, that this study examines how the institutions in the selected SSA countries can contribute meaningfully so that trade liberalization can have a noticeable impact on economic growth and increase the rate of investment that will boost the growth of aggregate output.

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1.2 STATEMENT OF RESEARCH PROBLEM

Temple (1999) stressed the importance of an economic environment that is consistent with the development and efficient use of resources. These include monetary and price stability, secure property rights and openness to international exchange that exert independent impacts on economic growth. Weak economic, political and cultural institutions as well as inappropriate trade policies can cause growth to be sub-optimal. For instance, good governance, which is a measure of quality of political institutions, has usually been considered as one of the key variables that enhance economic growth of any society. Economists have tried to look at the link between sound institutions embedded in good governance and economic growth; and have concluded that they are positively related. In any case, the level of economic growth depends, to a large extent on the strength of the institutions in place. For instance, in a study by Parsons and Robinson (2006), it was observed that Botswana experienced better growth than Zambia on account of having better institutions. There is a general discourse that the quality of institutions differs across countries because of belief and ideological differences. Since this is true for institutions, the study deduced that trade among countries can also be influenced by cultural beliefs and ideologies which would make a country to determine which country to trade with and which not to trade with (Siba, 2008).

Though the effects of trade on economic growth have been in the limelight since the existence of trade. It has been observed from literature that there are other factors that can affect the growth of a country; one of such factors is the quality of institutions prevalent in the country. Strong economic, political and cultural institutions have positive effect on the level of economic growth. For instance, Lavallee (2005) used the gravity model to examine the influence of proximity and quality of institutions on trade in one hundred and forty-five (145) countries for data spanning from 1984 to 2002, and governance indicators from International Country Risk Guide (ICRG). He found out that institutional proximity tends to

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increase trade, and concluded that corruption in both importing and exporting countries acts as a barrier to bilateral exports, which is harmful to trade and economic growth.

It has also been observed that a country can enhance its economic growth by freeing up its international trade but the presence of significant institutional issues on the side of imports hinders this from being achieved. Most countries can increase imports quite quickly once trade liberalization occurs, given suitable payment arrangements and an increase in the effective demand for imports. To maintain an acceptable or manageable trade balance, exports must also increase, and this is where many countries encounter some serious practical difficulties and barriers (Hare, 2006). On the contrary, Dollar and Kraay (2003) used the rule of law as a measure of institution and ratio of trade to GDP on cross-country level of one hundred and sixty-eight (168) for the average of the time frame of 2000-2001. The authors found out that changes in trade and changes in institutional quality had a substantial positive effect of trade on growth suggesting that trade and institutions jointly affect growth.

Siba (2008) in his study on the determinants of institutional quality in SSA countries found that ethnic fractionalization has an insignificant but positive effect on institutional quality. Most of these studies have only been carried out using the Asian, Americas and European countries (as case studies). The SSA countries have not been in the limelight at least not to the researcher’s knowledge. However, it has been observed from these SSA countries that there have been incessant crises occasioned by religious, ethnic and cultural disagreements amongst the people, as well as political and economic instability which have resulted in the slow pace of growth in these countries (Du, 2010). This has become a serious issue of concern as these countries have not been able to compete with the developed countries of the world.

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The studies carried out on SSA (Fajana, 1979; Easterly and Levine, 1997; Edwards, 1998; Gerrishon et. al., 2004; Du, 2010) focused on the effect of trade on economic growth and the role of institutions in the growth process of these SSA countries. But not much emphasis has been placed on the quality of institutions, that is, whether these SSA countries have weak or strong institutions that can affect the performance of trade to affect economic growth. In addition, these studies did not decompose these SSA countries into the sub-regions of Africa and did not also look at the interaction effect of trade liberalization and institutions on economic growth (this means that under which type of institutions would trade liberalization have a better impact on growth).

Therefore, this study attempts to fill the gap identified in the literature which is that, first, other studies did not carry out panel unit root tests on the data used. This study carried out panel unit root tests on the variables to see if the variables are stationary or non-stationary. This is done so as not to have spurious or nonsense results. Second, other studies did not categorize the SSA countries into the various sub-regions of Africa and the impact of the interaction effect between trade liberalization and each type of institution was not examined on economic growth. Third, this study also examined the interaction effects between trade liberalization and economic, political and cultural institutions on economic growth to see which type of institution has to be strong for trade liberalization to affect economic growth. The study also decomposed the selected SSA countries into sub-regions to see which sub-region had a better influence of trade liberalization and institutions on economic growth. By extension, this study was able to find out if strong institutions determine the extent of the impact of trade liberalization on economic growth. The study used different methods of estimation from other similar studies (the combination of LSDV and GMM techniques). The study also examined the relevance of institutions as it affects trade liberalization and hence economic growth in the selected SSA countries.

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1.3 RESEARCH QUESTIONS

The research questions that this study addresses include the following:

i.      How does trade liberalization affect economic growth in the selected sub-Saharan African (SSA) countries?

ii.       How do economic, political and cultural institutions affect economic growth in the selected SSA countries?

iii.       How does the interaction effect of trade liberalization and institutions affect economic growth in the selected SSA countries? and

iv.      What role does the quality of institutions play in influencing economic growth in the sub-regions of SSA?