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Openness and Governance: Evidence Across Countries

Fahim A. Al-Marhubi a
a
College of Commerce and Economics, Sultan Qaboos University, Al-Khoudh, Sultanate of Oman

To cite this Article Al-Marhubi, Fahim A.(2005) 'Openness and Governance: Evidence Across Countries', Oxford
Development Studies, 33: 3, 453 — 471
To link to this Article: DOI: 10.1080/13600810500199269
URL: http://dx.doi.org/10.1080/13600810500199269

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 Oxford Development Studies,
Vol. 33, No. 3&4, September–December 2005

Openness and Governance: Evidence Across

Countries
FAHIM A. AL-MARHUBI*

ABSTRACT The trade and governance literature suggest a link between the openness of an
economy to international trade and the quality of its governance. The paper tests this link using a
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data set on governance that is multidimensional and broad in cross-country coverage. The results
provide evidence that the quality of governance is significantly related to openness in international
trade. This association is robust to alternative specifications, different indicators of openness and
governance, and prevails for different sub-samples.

1. Introduction
The relationship between the openness of an economy to international trade and growth
has been the subject of numerous studies. Generally, these studies provide evidence that
greater integration into the world economy is associated with faster economic growth
(Edwards, 1998; Dollar & Kraay, 2003; Frankel & Romer, 1999).1 More recently, there
has developed an entirely separate strand of inquiry focusing on the role of governance
(institutional quality) in promoting growth and better development outcomes (Scully,
1988; Knack & Keefer, 1995; Mauro, 1995; Barro, 1996, 1997, 1999; Chong & Calderon,
1999, 2000; Hall & Jones, 1999; Kaufmann et al., 1999a; Aron, 2000; Acemoglu et al.,
2001; Rodrik et al., 2002). Collectively, these studies provide overwhelming evidence that
governance, broadly defined as the framework of rules, institutions and practices by which
authority is exercised, is a key element for a well-functioning market economy and
indispensable for sustained growth and equitable development.
These two lines of research have run in parallel without explicit recognition of each
other. Given the heated debate about the social and institutional consequences of
international economic integration, as reflected in the now-legendary Battle of Seattle in
1999 and the demonstrations that accompanied the 55th Annual Meeting of the
International Monetary Fund and the World Bank in Prague in September 2000, it is
surprising that there is almost no systematic analysis of the relationship between the
openness of an economy and the quality of its governance. Does integration into the global
economy really destroy citizen representation, debilitate democratic public decision-
making processes, and lead to a disregard for transparency, accountability and the rule of

*Fahim A. Al-Marhubi, Sultan Qaboos University, College of Commerce and Economics, P.O. Box 20,
Al-Khoudh, Post Code 123, Sultanate of Oman.
ISSN 1360-0818 print/ISSN 1469-9966 online/05/03– 40453-19
q 2005 International Development Centre, Oxford
DOI: 10.1080/13600810500199269
 454 F. A. Al-Marhubi

law, or does openness to international trade improve leadership accountability,

transparency of decision-making procedures, and interest representation? This article
attempts to answer this question by systematically examining the hypothesis that higher
levels of openness are associated with poor governance.
Motivating much of the work in this paper is the closely related research into the sources
of institutional differences across countries. This includes the empirical research on the
determinants of corruption across countries (Ades & Di Tella, 1999; Treisman, 2000; Wei,
2000; Knack & Azfar, 2003), studies that investigate cross-country differences in
democracy (Barro, 1996, 1999; Przeworski et al., 2000) and the La Porta et al., (1999)
work that emphasizes the importance of legal origins in shaping government performance.
This paper is also related to empirical work that investigates the implications of alternative
institutions and degree of trade integration with the rest of the world on countries’ level of
income and growth rates, and their relative significance compared with other influences on
development, such as geographic factors and economic policies (Mauro, 1995; Acemoglu
et al., 2001, 2002; Frankel & Romer, 1999; Hall & Jones, 1999; Przeworski & Limongi,
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1993; Rodrik et al., 2002; Tavares & Wacziarg, 2001). An important contribution of this
line of research is devising appropriate empirical strategies and choice of instruments for
demonstrating causal effects from trade integration and institutions to countries’ levels of
incomes and growth rates, since neither trade integration nor the quality of institutions is
exogenous.
Using a data set on governance that is multidimensional and broad in cross-country
coverage, the results show that the quality of governance is significantly related to
openness in international trade. This relationship is robust to the use of control variables,
alternative indicators of governance and openness, and different samples.
The rest of this article is structured as follows. The concept of governance and its
measurement is discussed in the next section. Section 3 provides some plausible
explanations for a positive correlation between an economy’s openness to international
trade and the quality of its governance. The methodology and the data are discussed in
Section 4, and the empirical results presented in Section 5. The last section summarizes
and concludes.

2. The Concept of Governance

There have been a number of attempts to define good governance. “Governance” is an
elusive concept. Different authors emphasize different aspects of the problem depending
on the subject of the author’s concern. This has led Isham et al. (1997, p. 219) to conclude
that “Governance, like religion, is a broad topic that inspires strong beliefs and is difficult
to measure reliably”.
Despite the absence of a precise definition, a consensus has emerged that governance
refers broadly to the manner in which authority is exercised. Defined in this way,
governance transcends government to include relationships between the state, civil society
organizations and the private sector. It includes the norms defining political action, the
institutional framework in which the policy-making process takes place, and the
mechanisms and processes by which public policies are designed, implemented and
sustained. Common governance issues include the limits of authority and leadership
accountability, transparency of decision-making procedures, interest representation and
conflict resolution mechanisms.
 Openness and Governance 455

If governance is difficult to define, it is even more difficult to measure.2 Time-series or

cross-sectional studies have deployed a variety of proxy measures, spanning indicators of
civil liberties, political violence frequencies, investor risk ratings and surveys of investors,
to aggregation of indexes. This paper relies on the recent definition proposed and the proxy
measures constructed by Kaufmann et al. (1999a, b). Kaufmann et al. (1999a, p. 1) defined
governance as “the traditions and institutions by which authority is exercised. This
includes (1) the process by which governments are selected, monitored and replaced (2)
the capacity of the government to effectively formulate and implement sound policies and
(3) the respect of citizens and the state for the institutions that govern economic and social
interactions among them”.
Operating on the principle that more information is generally preferable to less,
Kaufmann et al. (1999b) aggregated governance indicators from several sources into an
average or composite indicator—a poll of polls. The raw data used to construct the
composite governance indicators were based on subjective perceptions regarding the
quality of governance, often drawn from cross-country surveys conducted by risk agencies
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and surveys of residents carried out by international organizations and other non-
governmental organizations.3 Using an unobserved components methodology, Kaufmann
et al. (1999b)combined more than 300 related governance measures into six aggregate
(composite) indicators corresponding to six basic governance concepts, namely Voice and
Accountability, Political Instability and Violence, Government Effectiveness, Regulatory
Burden, Rule of Law and Graft.4
The first two governance indicators, “Voice and Accountability” and “Political
Instability and Violence”, summarize the process by which governments are selected,
monitored and replaced. The next two indicators, “Government Effectiveness” and
“Regulatory Burden”, capture the capacity of the government effectively to formulate and
implement sound policies. “Government Effectiveness” focuses on the inputs needed for
governments to produce and implement sound policies. “Regulatory Burden”, on the other
hand, focuses on the extent of market-unfriendly policies and perceptions of regulatory
burden. The last two indicators summarize the respect of citizens for the institutions that
govern their interactions. The “Rule of Law” index includes indicators that measure the
extent to which agents have confidence in and abide by the rules of society, thus reflecting
the success of a society in developing fair and predictable rules for social and economic
interactions. Finally, “Graft” measures perceptions of corruption, defined as the exercise
of public power for private gain. All six governance indicators are constructed so that they
have a mean of zero and a standard deviation of one. The indicators range between -2.5
and around 2.5, with higher scores corresponding to better governance.
Since the six governance indicators are strongly correlated—with correlations as high as
0.94—it is difficult to claim that they are genuinely measuring different dimensions of
governance within each country. As a result, this paper follows the methodology of Knack
& Keefer (1995) by aggregating the six governance indicators through simple averaging to
form a single governance indicator (KKZ). It is possible, however, that despite the strong
correlations between them, the six individual indicators are actually measuring different
things. Another argument is that countries that have good governance in one aspect are
also likely to have better governance in other aspects. To address these conflicting views,
the paper uses a compromise solution that aggregates the individual indicators into three
aggregate indicators. That is, Voice and Accountability and Political Instability are
averaged into a single indicator to represent how governments are selected, monitored and
 456 F. A. Al-Marhubi

replaced (KKZ1). Government Effectiveness and Regulatory Burden are averaged into a
single indicator to represent the capacity of the state to implement sound policies (KKZ2).
Rule of Law and Graft are averaged to produce an indicator that summarizes the respect of
the citizens and the state for the rule of law (KKZ3). As with the individual indicators,
higher values of these indicators indicate better governance. Summary statistics for the
governance indicators are presented in Table 1.

3. Openness and the Quality of Governance

The current state of knowledge regarding the relationship between the openness of an economy
and the quality of its governance remains underdeveloped. It is difficult to find formal models in
the literature that address this linkage explicitly. There are, however, different strands of the
literature on trade and corruption that provide, albeit implicitly, a variety of channels through
which active engagement with the rest of world can influence the quality of governance.
The first class of models that is relevant here are those from the literature on corruption.
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Ades & Di Tella (1999) and Treisman (2000), among others, suggested that more open
economies tend to have a lower level of corruption because the resulting greater
competition in product markets lowers rents and thereby reduces the rewards from
engaging in corruption. More recently, Wei (2000) has offered a different interpretation of
the connection between openness and corruption. Assuming that corruption and bad
governance drive out international trade and investment more than domestic trade and
investment, Wei (2000) provided empirical evidence that a “naturally” more open
economy—as determined by its size and geography—would find it optimal to devote more
resources to building good institutions. “Residual openness”—which potentially includes
trade policies—is found to be insignificant once “natural openness” is accounted for.

Table 1. Summary statistics

Variable Mean Standard deviation Minimum Maximum

Dependent variables and time period:
KKZ (2000/01) 0.168 0.871 2 1.548 1.743
KKZ1 (2000/01) 0.150 0.901 2 1.770 1.672
KKZ2 (2000/01) 0.195 0.817 2 1.922 1.667
KKZ3 (2000/01) 0.134 0.977 2 1.234 2.041
Independent variables and time period:
Latitude (1996) 0.276 0.189 0.011 0.722
British common law 0.378 0.487 0.000 1.000
Ethno-linguistic fragmentation 0.328 0.297 0.000 0.890
Per cent Protestant (1980) 14.118 22.506 0.000 97.800
Natural resource abundance (1970) 0.141 0.125 0.006 0.682
Openness (1985 trade shares) 64.540 38.268 13.160 209.520
Per capita income in logs (1960) 7.420 0.885 5.756 9.200
Summary statistics for KKZ, KKZ1, KKZ2 and KKZ3 refer to the samples that are used in the regressions in
Table 3. Except for per capita income, summary statistics for the independent variables refer to the sample
that is used for the regression in the first column of Table 3. For per capita income, the summary statistics
refer to the sample used in the first column of Table 4. Data on British common law and ethno-linguistic
fragmentation, which were obtained from La Porta et al. (1999), are based on several sources and do not
share the same time period.
 Openness and Governance 457

Second, the relationship between the openness of an economy and the quality of its
governance may reflect deliberate policy choices to harmonize a country’s economic and
social institutions with those of its trading partners and a willingness to submit to
disciplines imposed by membership of international institutions. For example, member-
ship in the World Trade Organization involves the adoption of a set of institutional and
governance norms and disciplines such as non-discrimination in trade, harmonization of
regulatory standards, transparency, and patent and copyright protection. Such disciplines,
according to Rodrik (1999, p. 32), “impose a certain degree of predictability, transparency,
rule-bound behavior, and nondiscrimination in areas of policy often subject to discretion
and rent-seeking”. Policy and institutional harmonization may also enhance the credibility
and legitimacy of domestic policy and institutions, and thereby help governments to
overcome weaknesses in governance.
Third, the openness-governance link may be the result of the potentially increased costs
associated with greater integration. Greater openness provides international traders and
investors with an exit option in response to adverse policy shifts and reversals. The
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opportunity to reduce risk through international diversification in response to adverse

policies can trigger economic agents to exercise their exit option, leading to outflows of
resources and economic activity. Exposure to this new set of risks generates stronger
incentives to adopt governance structures that constrain policy choice. Among the
institutions that might have this effect is the separation of powers (among different
government organs such as the executive, legislative and judiciary), which helps ensure
that the policy-making process is subject to review and constraints from multiple centres
of government power. Separation of powers may also serve as an indirect mechanism for
policy commitment and may be an efficient way of dealing with the risk of errors (Laffont
& Meleu, 2001).
Another channel through which openness may affect the quality of governance has
to do with the recently identified costs of surprise monetary expansions in more open
economies. Although growing international integration may cause economies to
become less prone to inflation, Romer (1993), for example, argued that the benefits of
higher output from surprise monetary expansion are smaller, while the consequent
costs of real depreciation are larger the more open the economy, respectively. Thus,
by raising the cost that must be paid for bad policies, openness to world markets
generates stronger incentives to create governance structures such as independent
central banks and autonomous tax agencies to free monetary policy and tax collection
from political influence.
Integration into the world economy may lead to gradual social and cultural changes that
make better institutions and governance structures more likely to emerge and survive. The
global flow of information, a by-product of engagement with the world economy, exposes
citizens to alternative sources of information, ideas and organizational and managerial
arrangements. This helps to create a more confident, more demanding and independent-
minded citizenry that can form the backbone of more representative forms of government.
Contact with the ideas and practices of other societies could also help nurture civil
institutions that can offer ideas and influence outside government in the policy steering
process. Thus, according to Rodrik (1999, p. 31), “Civil liberties and political freedoms
are among the most imported concepts in the developing world; the demands for
democracy to which these ideas give rise are a direct product of openness in this broad
sense”.
 458 F. A. Al-Marhubi

A final explanation for the openness-governance link relates to the use of high-quality
governance as a risk-reducing device, especially in more open economies. According to
Rodrik (1999), high-quality governance imparts resilience to an economy by insulating it
from the destabilizing effects of external shocks. On the one hand, openness leaves
countries susceptible to external shocks—changes in the terms of trade, spikes in world
interest rates and sudden reversals in capital flows—and unless prompt and appropriate
adjustments are undertaken, the costs of these shocks will be magnified, with debilitating
consequences for the economy.5 On the other hand, uncertainty about the distributional
consequences of adjustment at the level of the individual and disagreement over how the
burden of adjustment is distributed across groups in the economy can prevent or delay
adjustment, even when it is known that a majority will benefit from the adjustment
(Alesina & Drazen, 1991; Fernandez & Rodrik, 1990; Rodrik, 1993). Consequently,
making the most of openness requires high-quality institutions of governance to adjudicate
conflicts of interest within a framework of rules and accepted procedures so as to bring
about the social bargains necessary for macroeconomic adjustment; and precisely because
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of their increased exposure to external shocks, high-quality governance will be all the
more important for more open economies in terms of managing and ameliorating the
conflicts engendered by greater openness.

4. Methodology and Data

The relationship between the quality of governance and openness in international trade
was investigated by regressing the different measures of governance on openness and a
wide range of control variables that were considered important determinants of
governance in past studies (Ades & Di Tella, 1999; La Porta et al., 1999; Treisman, 2000).
Although unusual in this literature, the analysis relied on cross-country regressions only
and no panel data were used due to the limited availability of time-series data on both the
measures of institutional quality and many of the control variables.
The control variables include the logarithm of real per capita GDP, dummy variables for
developing countries and countries associated with a legacy of British common law
origins, the percentage of the population in each country that belongs to the Protestant
affiliation, ethno-linguistic fractionalization, strength of western European influence and
the share of primary exports in GDP. Lack of space precludes detailed consideration of the
theoretical underpinning for each of the control variables, but a few remarks on expected
signs are in order.6
First, real per capita income and the dummy variable for developing countries are
included because theory and evidence suggest an important positive link between the level
of economic development and the quality of governance (Inglehart, 2000; La Porta et al.,
1999). Other researchers, however, see causality pointing precisely in the opposite
direction (Scully, 1988; Hall & Jones, 1999; Kaufmann et al., 1999a). To avoid partially
problems associated with simultaneity, the analysis follows La Porta et al., (1999) by using
initial values for per capita income, measured here four decades preceding the
measurement period for governance (2000 – 01). With per capita income determined prior
to the period of governance looked at here, simultaneity bias should no longer pose a
problem.
Despite the theoretical ambiguity regarding the relationship between natural resource
abundance and governance, the share of primary exports in GDP is included since many
 Openness and Governance 459

authors found that natural resource abundance is associated with poor governance (Ades &
Di Tella,1999; Tornell & Lane, 1999; Treisman, 2000). The percentage of the population
that belongs to the Protestant affiliation is included since cultural theories of governance
tend to emphasize religious affiliation as an important determinant of governance.
Protestantism is expected to influence governance positively because it is more egalitarian,
less hierarchical and more individualistic relative to other religious affiliations. In
addition, Protestantism both encourages and requires social institutions that protect
individual rights. Chief among these are conceptions of individual ownership and equality
before the law.
Ethno-linguistic fractionalization and the origin of a country’s legal system are included
because theory and evidence suggest an important link between society’s re-distributive
proclivities and the political orientation of the state toward the protection and security of
property rights and the quality of governance (La Porta et al., 1999). Ethno-linguistic
fractionalization is posited to have a negative effect on governance because in ethnically
diverse societies, public officials are more likely to restrict political freedoms, to be more
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interventionist, inefficient and corrupt. The origin of the legal system, captured by a
dummy variable representing British common law origins, should have a positive effect on
governance because, relative to other legal systems, British common law represents
greater protection of property rights against the state and “can be taken as a proxy for the
intent to limit rather than strengthen the state” (La Porta et al., 1999, p. 232). Finally,
following Hall & Jones (1999) and La Porta et al., (1999), distance from the equator is
used as proxy for the strength of past western European influences, which is posited to be
conducive to the development of good governance.
Data on the control variables were from various sources. Data on real per capita GDP for
1960 were from the PWT5.6 (Summers and Heston, 1991). Data on the share of primary
exports to GDP were from Sachs & Warner (1995). On the basis of the IMF classification,
a dummy variable was created that took a value of one for developing countries and zero
otherwise. Finally, data on ethno-linguistic fractionalization, distance from the equator,
countries with common law origins and the percentage of Protestant affiliation were from
La Porta et al., (1999). Descriptive statistics for the variables of interest are reported in
Table 1.

5. Empirical Results
This section reports the results on the relationship between openness and the quality of
governance for a cross-section of countries. Section 5.1 reports the results using trade
shares as a measure of openness to international trade. The following subsections examine
the robustness of the relationship to the use of additional covariates, estimation methods,
and alternative indicators of openness and governance.

5.1 Trade Shares and the Quality of Governance

A first impression of the correlation between the different measures of governance and
openness, measured by trade shares, is provided by the scatter plots in Figure 1. The
vertical axis represents the different indicators of governance measured over the period
2000 –01. Along the horizontal axis is shown the degree of openness, measured as the
1985 share of exports and imports in GDP. Data were taken from Kaufman et al., (1999b)
 460 F. A. Al-Marhubi
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Figure 1. Openness and governance indicators.

for governance and from the Penn World Table, Mark 5.6 for openness.7 Although the data
points in the scatter plots are affected by other factors, which will be controlled for in the
following more systematic analysis, there seems to be a positive association between
openness, measured by the share of trade in GDP, and the quality of governance.
The univariate regression results reported in Table 2 tend to confirm our initial
impression regarding the relationship between openness and governance.8 The coefficients
on openness are positive and statistically significant for all governance regressions. The
fraction of the cross-country variation in governance explained by the regressions is also
non-trivial: openness alone accounts for over 12% of the cross-country variation in most of
the governance indicators. Note, however, that the univariate specification may be subject
to omitted-variable bias if it excludes any factor correlated with openness that may affect

Table 2. The relationship between governance and openness: ordinary least squares estimation

KKZ KKZ1 KKZ2 KKZ3

CONSTANT 2 0.408 (3.19)*** 2 0.365 (2.521)** 2 0.403 (3.23)*** 2 0.496 (3.76)***
OPENNESS 0.008 (5.07)*** 0.007 (3.77)*** 0.008 (5.40)*** 0.009 (5.72)***
R-squared 0.12 0.09 0.13 0.14
F-statistic 16.98*** 11.93*** 18.99*** 20.47***
Observations 123 125 125 125
RES 0.005 (1.17) 0.004 (0.88) 0.006 (1.57) 0.005 (1.21)
t-Statistics based on White’s (1980) heteroscedasticity-consistent covariance matrix.
*** and ** refer to significance levels of 1% and 5%, respectively.
 Openness and Governance 461

the quality of governance. To address this possibility, the empirical analysis that follows
investigates the robustness of the results to the inclusion of a wide range of covariates.
An initial analysis of the data indicated large partial correlations between many of the
independent variables and per capita income. Thus, to understand how the results depend
on the specification and to address concerns about possible omitted-variable bias and
multicollinearity, Tables 3 and 4 present results with and without the per capita income
variable. The results are satisfactory for cross-sectional data. The regressions explain
about 63– 81% of the cross-country variation in governance and, more importantly, the
coefficient estimates on openness are positive and statistically significant in all the
governance regressions.
As for the control variables, most of the coefficient estimates have the expected signs
and many of them are statistically different from zero at standard significance levels. The
results in Table 3, for example, show that history of western European influence (measured
by distance from the equator), common law legal origins and ethno-linguistic
heterogeneity have coefficient estimates that are statistically significant and with the
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expected signs. These results are broadly consistent with the findings of Ades & Di Tella
(1999) and Treisman (2000) on corruption, and those of La Porta et al., (1999) on
government performance. As in previous work in this area (La Porta et al., 1999), the
inclusion of per capita income increases the explanatory power of the regressions
appreciably, but reduces the significance of the other control variables, especially ethno-
linguistic fractionalization, which loses statistical significance.
In terms of magnitude, the coefficient estimates on openness are also economically
significant. For example, the estimated coefficient on openness in the first column of Table
3 implies that a one standard deviation increase in openness (38.27) would increase
governance, measured by KKZ, by 0.19 units. If governance is at its mean value of 0.168
at the outset for this sample, then this implies a 113% increase. The estimated coefficients
on openness from the other columns also suggest a similarly large economic relationship
between openness and governance.

5.2 Robustness to Additional Covariates

An important question is whether the openness indicator is capturing the possible effects
of omitted variables and heterogeneity in the sample. These issues are explored by
considering the robustness of the openness-governance link to the use of additional
covariates and alternative samples.9
With respect to additional covariates, Huber et al., (1993), among others, have argued
that changes in class and social structures associated with development are of greatest
importance to democracy and other aspects of governance. This is explored by introducing
measures of urbanization and life expectancy separately to substitute for per capita income
in the governance regressions.10 As expected, these variables are found to have a positive
and significant effect on the quality of governance, but their inclusion does not change the
results in any qualitative way: the estimated coefficients on the trade shares remain
significant for all governance indicators and their signs consistently show a positive effect
on the quality of governance.
Several authors also concluded that larger countries tend to have more corrupt
governments than small nations (Fisman & Gatti, 2000; Treisman, 2000). Adding the
logarithm of population or other explicit measures of country size—such as the logarithm
 Downloaded By: [UNAM] At: 22:46 10 March 2010

462

Table 3. The relationship between openness and governance: ordinary least squares estimation
F. A. Al-Marhubi

KKZ KKZ1 KKZ2 KKZ3

CONSTANT 0.338 (1.34) 0.355 (1.21) 0.273 (1.13) 0.335 (1.12)
OPENNESS 0.005 (4.38)*** 0.006 (3.38)*** 0.005 (3.43)*** 0.006 (4.94)***
LATITUDE 1.144 (2.44)** 0.997 (1.78)* 1.204 (2.80)*** 0.198 (2.34)**
COMMON LAW ORIGINS 0.225 (1.94)* 0.107 (0.81) 0.211 (1.63) 0.347 (3.02)***
PROTESTANTISM 0.002 (1.14) 0.003 (1.56) 0.0002 (0.11) 0.003 (1.19)
ETHNO-LINGUISTIC 20.655 (3.14)*** 2 0.661 (2.84)*** 20.554 (2.51)** 20.633 (2.89)***
NATURAL RESOURCE 20.198 (0.51) 2 0.151 (0.332) 20.264 (0.62) 0.243 (0.57)
DEVELOPING DUMMY 20.925 (5.72)*** 2 0.881 (5.09)*** 20.763 (4.73)*** 21.132 (5.54)***
R-squared 0.73 0.64 0.63 0.78
F-statistic 34.51*** 23.19*** 22.14*** 45.11***
Observations 98 100 99 99
RES 20.0014 (0.49) 2 0.0027 (0.79) 0.0004 (0.12) 20.0019 (0.64)
t-Statistics based on White’s (1980) heteroscedasticity-consistent covariance matrix.
*** ,** and * refer to significance levels of 1%, 5% and 10%, respectively.
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Table 4. The relationship between openness and governance: ordinary least squares estimation

KKZ KKZ1 KKZ2 KKZ3

*** *** ***
CONSTANT 22.455 (3.49) 2 2.514 (2.87) 2 2.561 (3.45) 22.370 (3.30)***
OPENNESS 0.005 (3.56)*** 0.004 (2.39)** 0.004 (2.91)*** 0.006 (4.32)***
LATITUDE 1.052 (2.30)** 0.897 (1.68)* 1.095 (2.52)** 1.129 (2.12)**
COMMON LAW ORIGINS 0.213 (1.89)* 0.110 (0.85) 0.208 (1.63) 0.307 (2.82)***
PROTESTANTISM 0.0007 (0.34) 0.001 (0.65) 2 0.001 (0.58) 0.002 (0.79)
ETHNO-LINGUISTIC 20.239 (1.09) 2 0.267 (1.04) 2 0.121 (0.50) 20.277 (1.25)
NATURAL RESOURCE 20.524 (1.06) 2 0.387 (0.62) 2 0.617 (1.13) 20.649 (1.36)
DEVELOPING COUNTRY 20.556 (3.30)*** 2 0.499 (2.44)** 2 0.396 (2.40)** 20.769 (3.71)***
PER CAPITA INCOME (log) 0.339 (4.20)*** 0.354 (3.66)*** 0.345 (4.00)*** 0.332 (4.02)***
R-squared 0.77 0.68 0.68 0.81
F-statistic 35.38*** 23.14*** 22.47*** 45.57***
Observations 93 95 94 94
RES 20.0016 (0.56) 2 0.0035 (1.05) 2 0.0003 (0.10) 20.0010 (0.35)
t-Statistics based on White’s (1980) heteroscedasticity-consistent covariance matrix.
*** ,** and * refer to significance levels of 1%, 5% and 10%, respectively.
Openness and Governance
463
 464 F. A. Al-Marhubi

of land area—on the right-hand side of the governance regressions does not change the
results in any fundamental way: the trade ratios remain statistically significant in most of
the governance regressions. The basic results continue to hold even with the inclusion of
other variables emphasized in previous work (other legal origin variables such as French,
German, Scandinavian and socialist; other religious affiliations variables such as per cent
of Catholic, Muslim and other affiliation; income inequality; government size).
To investigate whether the results were driven by heterogeneity between developing
and industrial countries, all the governance regressions were re-estimated, excluding
industrial countries from the sample. The results from this sub-sample of only developing
countries are qualitatively similar to those reported for the full set of countries: the
estimated coefficients on the measures of openness are significant for most of the
governance indicators and their signs consistently show a positive effect on the quality of
governance.
Finally, to avoid placing a disproportionate weight on the few countries with very high
trade ratios in determining the coefficient estimates of the regression, the logarithmic
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transformation of the trade shares was also experimented with. Unlike the histogram for
trade shares, which has an asymmetric distribution with a few observations located at the
upper end of the distribution, the logarithm of trade shares has a much more balanced
distribution. Additionally, using the natural logarithm of openness captures the possible
non-linearity in the effect of openness on the quality of governance Again, the results
remained unchanged: the coefficient estimates on the logarithm of trade shares remain
positive and statistically significant.

5.3 Validity of Ordinary Least Squares Estimation

Overall, the results show a strong correlation between openness, measured by trade shares,
and the quality of governance. Nevertheless, there are a number of potential reasons for
not interpreting this relationship as causal. It is possible and quite likely that countries with
high-quality governance choose or can afford greater openness because good governance
allows countries to exploit the opportunities and manage the risks from international trade
(Rodrik, 1999). Hence, the finding of a relationship between trade shares and governance
based on ordinary least squares (OLS) cannot be interpreted as causal. Another problem is
that of simultaneity. In principle, it is possible that openness leads to improvements in
governance and that this makes the introduction of greater openness more likely, which
again promotes the quality of governance. This is so is because high-quality governance
may enhance the gains and cushion some of the risks of greater openness. In the presence
of these additional positive feedback effects, the positive overall impact of openness on
governance may be higher than previously estimated. As a result, OLS estimates may be
biased and inconsistent (Pindyk & Rubinfeld, 1998, p. 353).
To address these concerns, it seems reasonable to carry out some additional econometric
work. First, partially to avoid problems associated with reverse causality and simultaneity,
initial values for the trade shares (annual trade shares averaged over the period 1960 –69)
were used. That is, the trade shares were measured four decades preceding the
measurement period for governance (2000 –01). With the trade shares determined prior to
the period of governance looked at here, reverse causality and simultaneity bias should no
longer pose a problem. The results, not reported, are again in line with those presented in
Tables 2– 4 using 1985 trade shares.
 Openness and Governance 465

Given the high serial correlation in trade shares across time, the use of trade shares
measured in an earlier period may not be enough to avoid the problem of simultaneity.11
To address this concern, the exogeneity of the trade shares to the governance indicators is
explicitly tested for. An appropriate tool is the Hausman (1978) specification test. The first
step is to obtain residuals from an auxiliary regression in which the trade shares are
regressed on the above hypothesized exogenous variables (latitude, common law origins,
per cent of Protestants, ethno-linguistic fragmentation, natural resource abundance,
dummy for developing country and per capita income) and an instrumental variable—a
source of exogenous variation in openness that is uncorrelated with the quality of
governance or affected by policies and other factors that influence governance. The next
step is to re-estimate all the governance equations including the residuals (RES) from the
first step. Under the null hypothesis that openness is exogenous, the variable RES should
not be significant. If the coefficient on RES is significant, then OLS estimates are biased
and inconsistent and two-stage least squares may have to be employed as an estimation
procedure.
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Following the literature, in this paper the logarithm of land area, the logarithm of population
and a dummy variable for landlocked countries as instruments for the trade shares are used.12
The results of the exogeneity test corresponding to the different specifications of the
governance regressions in Tables 2–4 are reported in the last row of the same tables. These
results show that the coefficient estimates on the residuals (RES) obtained from the auxiliary
regressions are not statistically significant at traditional significance levels, indicating that the
trade shares can be treated as exogenous to the governance indicators. This suggests that the
results based on OLS estimation reported in Tables 2–4 provide reliable estimates of the
causal effect of openness on the quality of governance.

5.4 Robustness to Alternative Openness and Governance Indicators

A major weakness of using trade ratios is that they may not necessarily be related to trade
policy. Other factors, such as country size and foreign capital inflows, also affect trade:
large countries, for example, generally have smaller trade shares. More importantly, a
country can distort trade heavily and still have a high trade ratio. In the absence of an ideal
measure of policy-induced openness, and where the vast majority of openness indices are
subject to conceptual limitations, placing sole reliance on trade shares as an indicator of
policy-induced openness raises serious concern about the reliability of the results
(Edwards, 1998). For the significance of the openness and governance relationship to be
persuasive, the results need to be robust to the use of alternative indicators of openness.
The widely used policy-induced index of openness created by Sachs & Warner (1995) is
considered first. This index (SW-INDEX) reflects deliberate trade policy choices based on
direct measures of trade barriers, such as tariff rates, quotas and black market exchange
rate premiums for the period 1970 –90. For each year, a dummy variable was constructed
that takes a value of zero if any one of the following conditions holds over that year:
average tariff rates are over 40%; non-tariff barriers cover 40% or more of imports; the
country operates under a socialist economic system; there is a state monopoly of the
country’s major exports; and the black market premium on its official exchange rate
exceeded 20% in the 1980s or 1990s. By averaging the data over the period 1970 –90, this
index measures the fraction of years during the period 1970 –90 in which the country was
rated as an open economy according to the above criteria.
 466 F. A. Al-Marhubi

The next openness indicator is the Dollar (1992) index of outward orientation (D-INDEX).
This index measures the extent to which a country’s actual real exchange rate (the index of a
country’s relative price level) is distorted away from its free trade level by the trade regime,
where the latter is measured by the real exchange rate that corresponds to a country’s
particular resource endowment. If all goods were tradable and there were no trade barriers,
these real exchange rates (relative price level indices) would all be equal across countries.
Hence, if there were no non-tradable goods, cross-country variation in the price level indices
could be taken directly as a measure of outward orientation caused by trade policy. However,
even with free trade, the exchange rates (relative price level indices) will not all be equal as
long as there are non-tradable goods whose prices differ across countries. To filter out that part
of the differences in prices between countries due to country differences in the prices of non-
tradables, Dollar first regressed their relative price level indices on the level and square of
GDP per capita, population density and regional dummies as measures of factor endowment.
The predicted relative price level is then considered as the hypothetical free trade level.13 The
Dollar index of outward orientation was then constructed as the actual relative price level
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divided by the predicted relative price level. Higher values of the index indicate high levels of
trade distortion and lower levels of outward orientation.
Another policy-induced indicator of openness is the Gwartney & Lawson (2002) trade
openness index (G-INDEX), designed to measure the extent to which policies interfere
with international exchange. This index is based on measures of tariff rates, the black
market exchange rate premium, restriction on capital movements and the actual size of the
trade sector compared with the expected size.14 Each of these four components was
assigned a rating between zero and one, with one indicating greater openness. The ratings
for each of these four components were than averaged to derive the overall trade openness
index (G-INDEX) for various years during the period from 1980 to 1998. Higher ratings
on the G-INDEX are indicative of greater openness.
Another straightforward indicator of policy openness is trade ratios adjusted for the
potential influence of various structural characteristics of the economy such as land size,
population size and factor endowment structure. Structural-adjusted trade shares can be
constructed simply as the residuals from a trade shares regression that explicitly accounts
for the influence of the structural factors on trade ratios. For the purposes of this paper, two
structural-adjusted trade shares were considered. The first was constructed using the data
from Frankel & Romer (1999) and was measured as the difference between the actual trade
shares minus their constructed/predicted traded shares created on the basis of geographic
characteristics (STR-ADJUSTED1).15 The second structural-adjusted trade share measure
was obtained by using the residuals from a regression of trade shares on the logarithm of land
area, the logarithm of population size, a dummy variable with a value of one for landlocked
countries and zero otherwise, and real per capita GDP (STR-ADJUSTED2).
Table 5 presents the results for KKZ (average of the six governance indicators) obtained
from using the alternative indicators of openness. To conserve space, Table 5 reports only
the size and statistical significance of the coefficients on the alternative indicators of
openness. With the exception of the Dollar index (D-INDEX), the estimated coefficients
on all remaining openness indicators have the expected signs and are statistically
significant, suggesting with consistency that there is a significantly positive relationship
between the quality of governance and openness.16
Finally, the paper examines whether the relationship between the quality of governance
and openness is robust to the use of alternative indicators of governance quality widely
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Table 5. The relationship between governance (KKZ) and alternative openness indicators: ordinary least squares estimation

SW-INDEX D-INDEX G-INDEX STR-ADJUSTED1 STR-ADJUSTED2

0.388 (3.10)*** 2 0.002 (1.54) 0.158 (5.75)*** 0.006 (3.09)*** 0.004 (2.18)**
R-squared 0.78 0.76 0.81 0.77 0.75
F-statistic 33.11*** 33.24*** 38.74*** 34.31*** 31.02***
Observations 87 91 81 93 92
t-Statistics based on White’s (1980) heteroscedasticity-consistent covariance matrix. The specification of the equations follows that of Table 4.
*** and ** refer to significance levels of 1% and 5%, respectively.
Openness and Governance
467
 468 F. A. Al-Marhubi

used in the literature. These include the degree of corruption, the protection and
enforcement of property rights, and the extent of democracy. Corruption is measured by
the Transparency International (TI) Corruption Perceptions Index for year 2000,
democracy is measured as the average of the Freedom House Political Rights and Civil
Liberties Index for the year 2000 (Freedom House, 2001) and the property rights index for
year 2003 is obtained from the Heritage Foundation (2003). The results, not reported,
suggest that the relationship between openness, measured by actual trade shares, and the
quality of governance is robust to the use of alternative indicators of governance. These
results are also robust to the use of alternative indicators of openness.

6. Conclusions
The link between the openness of an economy and the quality of its governance has been
investigated empirically in this paper. The main argument is that more open economies
have better governance structures. This hypothesis has been tested by estimating
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governance regressions with data from a large cross-section of developing and developed
countries. The results show that the quality of governance is related significantly to
openness in international trade. This relationship is robust to the use of control variables,
alternative indicators of governance and openness, and different samples.
The policy implications are quite encouraging. The significance of trade suggests that
globalization, which is a major dynamic of our time, can enhance countries’ incentives to
build good governance. By reducing the costs of transportation and communication
through technological advancement, globalization can potentially increase the extent to
which countries are integrated with the rest of the world. As a result, and contrary to
popular perceptions, openness to the world economy could be an important force for
positive social change with important spillover effects on governance.
The results also suggest that the expansion of trade may have important implications for
economic performance. If greater openness leads to better governance, and better governance is
associated with higher growth, as suggested in much of the recent literature on governance, then
this underlines the importance of openness for growth via its impact on governance, in addition
to its direct impact on growth through channels emphasized in the new theories of growth.
Finally, the results suggest some directions for further research. Remaining for future
theoretical research is the task of explicitly modelling the transmission channels underlying
the openness-governance relationship and how trade openness and governance are jointly
determined in a political economy equilibrium framework. On the empirical side, future
research based on historical analysis of specific countries’ experiences to complement cross-
country investigations might yield important insights. Another possible direction is to expand
the framework of the empirical analysis from a cross-section to a panel. Research in both
directions, however, requires additional data that are not currently available.

Notes
1
On the other hand, Rodriguez & Rodrik (2000, p. 266) are critical about much of this literature and conclude that
“the nature of the relationship between trade policy and economic growth remains very much an open question”.
2
For a summary of alternative governance indicators used in the literature, see World Bank (2000).
3
For a discussion of why such subjective data are useful in measuring governance, see Kaufmann et al. (1999a,
pp. 2–5) and Aron (2000, p. 128).
 Openness and Governance 469
4
The data set can be downloaded from the World Bank web site at www.worldbank.org/wbi/governance/-
datasets/htm.
5
For example, Easterly & Kraay (2000) reported that volatility of the terms of trade shocks as a percentage of
GDP is higher in small states, which is largely due to their greater openness.
6
For a recent and comprehensive survey on theoretical underpinnings, evidence and citations, see La Porta et al.
(1999) and Treisman (2000).
7
The choice of 1985 values for openness is to maintain consistency with the rest of the openness data used by
Frankel & Romer (1999). The use of other time periods or averages, however, does not affect the results in any
fundamental sense.
8
Although the governance indicators are subject to measurement error, OLS estimation is valid when
measurement error is in the dependent variable.
9
To conserve space, the results of this subsection are not reported, but are available from the author upon
request.
10
Data on urbanization and life expectancy were obtained from the World Bank Development Indicators 2001.
For most countries, values of the variables are for the early 1960s to minimize the possibility of reverse
causality and simultaneity.
11
For example, the correlation between 1985 trade shares and the average annual trade shares for 1960–69 is
0.81.
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12
Land area and population size were taken from World Bank Development Indicators 2001, while data on
landlocked countries were taken from CIA (2004).
13
The predicted relative price levels are considered as the free trade levels because if factor price equalization
does not hold, then prices of non-tradable goods should vary systematically with factor endowments, and
relative price levels would similarly vary systematically with endowments.
14
The expected size of the trade sector (trade as a share of GDP) was derived from a regression of trade shares on
population, geographic size, miles of coastline and a location variable that measures the relative distance of
each country from the distribution of world demand.
15
The constructed/predicted trade shares are obtained first by regressing bilateral trade flows on countries’
geographic characteristics (countries’ sizes, their distance from one another, whether they share a border and
whether they are landlocked). For each country, the fitted values from the bilateral trade equation are then
aggregated on the basis of the coefficients estimated to obtain an estimate of the geographic component of the
country’s overall trade. As result, these constructed/predicted trade shares reflect the variation in trade that is
due to geographic factors.
16
Using KKZ1, KKZ2 and KKZ3 produces similar results.

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