College of finance, Management and Development

Department of Development Economics

Econometrics II : Group Assignment
Title: The effect of institutional quality on economic growth in sub-saharan
Africa
Weekend 2016 program Section II
Group members name ID No.

1.Mulualem Yakob………………………………………………………..ECSU2203403
2.Genanaw Kassa………………………………………..………..……....ECSU2203333
3.Fentahun Lakie………………………………………………….…….. ECSU2203327
4.Mengistu Birhan………………………………………………………..ECSU2203381

 Submitted To: Dessalegne (PhD)

 Submission date: February 06 , 2024

Feb, 2024

Addis Ababa, Ethiopia

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Table of Contents
1.Introduction..............................................................................................................................................1
2.Literature review......................................................................................................................................2
3.Data and Methodology.............................................................................................................................4
3.1 Data...................................................................................................................................................4
3.2 Methodology.....................................................................................................................................4
4.Descriptive Analysis..................................................................................................................................6
5.Empirical Results and Discussion..............................................................................................................7
6.Conclusion..............................................................................................................................................10
References.................................................................................................................................................11

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1.Introduction
It has long been known how important institutions are to economic growth and development;
this was highlighted in the works of Adam Smith and, more recently, David Landes (1998), and
was acknowledged by Douglass North's 1993 Nobel Prize. Nonetheless, there has been a
resurgence of interest in this topic in recent years, with studies being conducted on the causes
of institutional variations among nations, the ways in which institutions may influence economic
performance, and the quantitative significance of these connections.

Institutions indeed matter, but their quality is what determines their impact in the growth and
development process. As submitted by Alonso and Garciamatin (2004), institutions do not work
if they are not capable of shaping agents’ behaviour in an effective manner; implying that
institutions that are not made to be respected by agents may be unfit for purpose, thus
hindering their potency. Institutions in an economy function as transaction cost reducer, and a
gauge for what is right and wrong in social interactions.

It has been noted that the majority of SSA nations have extremely subpar institutional
performance records. For example, Nigeria's high level of corruption, mishandling of public
assets, and ongoing issue of extra-budgetary spending have all been attributed to institutional
failure. According to the Word Governance Indicators (WGI, 2020), the SSA region's nations
received low marks for voice and accountability, rule of law, absence of violence, and
government efficacy.

There could be an issue with rating bias because the institutional data that researchers have
used are primarily subjective (Chong et al., 2000). Since governance quality cannot be
measured, empirical researchers employ indicators rather than real measures of governance
(Kagundu 2006). Thus, the six indices of governance proposed by Kaufmann and Kraay (2011)
will be used in this investigation. This paper used a two-step system GMM to estimate dynamic
panel data, in contrast to other earlier studies that used OLS, fixed effect, and random effect
estimators. One benefit of using the dynamic GMM technique is that it adds control over
heterogeneity and endogeneity as well as dynamics.

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For this reason, estimates derived from GMM approaches have greater validity than estimates
derived from static models.

2.Literature review
The theoretical and empirical research supporting the relationship between institutional quality
and production growth is the main emphasis of this section.

The ambiguity surrounding the relationship between institutional quality and income is a well-
documented issue in the literature. Numerous studies have explored this relationship, but
consensus has not been reached on the correct measure of institutional quality. This lack of
agreement has led to divergent results and varying conclusions.

Researchers have employed different approaches to measure institutional quality, including

qualitative assessments, quantitative indicators, and composite indices. These approaches often
capture different aspects of institutional quality, such as the rule of law, property rights
protection, government effectiveness, regulatory quality, and control of corruption.

In order to increase economic output, the Solow-Swan neoclassical growth model places a
strong focus on labor, capital, and technological advancement (Solow, 1956; Swan, 1956). Later
on, Mankiw, Romer, and Weil (1992) added the accumulation of human capital to this.
Nonetheless, this is no longer the case as institutional quality is one of the main factors
influencing sustainable development and has taken center stage among other factors. According
to the "institutions' quality hypothesis" (Alexiou, Tsaliki, & Osman, 2014), economic
development is influenced by the institutional framework in which economic agents interact
with one another in an economy. This perspective holds that a society's "rules of the game,"
which are determined by the dominant behavioral norms, both explicit and implicit, and their
capacity to provide suitable incentives for desired economic behavior, are what really count
(Rodrik). Subramanian (2003) as well.

Prior research focused on the connection between political institutions and economic
development (Wittman, 1995; Clague et al., 1999; Wu and Davis, 1999). However, as time has
progressed, new measures have led to the discussion of a variety of institutional issues

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(Butkiewicz and Yanikkaya, 2006; Kostevc et al. 2007). Research conducted by Dawson (2003)
and Adkins and Savvides (2002), for example, demonstrated that institutions that support
economic freedom have a favorable impact on economic performance.

The study by Devangi, Perera, and Lee (2013) examines whether poverty and inequality in South
Asia (Bangladesh, India, Pakistan, and Sri Lanka) and East Asia (China, Indonesia, Malaysia,
Philippines, and Thailand) have decreased as a result of economic growth and institutional
quality. The System Generalized Method of Moments (GMM) estimation of 1985–2009 is used
in the investigation. The findings indicate that deteriorating democratic accountability,
bureaucratic quality, and corruption are linked to widening wealth disparities.

Using data from 12 West African nations between 1996 and 2015, lheonu et al. (2017)
examined the potential effects of institutional quality on output variety. FE, RE, and the panel
2SLS approach were used in the investigation. Rule of law, regulatory quality, government
efficacy, and corruption control made up the institutional quality index that was employed.
Economic growth is positively and strongly impacted by institutional quality, according to the
results.

OLS, 2SLS, and GMM were utilized by Aixalá et al. (2008) to investigate production growth and
institutional quality.

A sample of wealthy and impoverished economies from 1996 to 2000 was employed in the
study. The outcome demonstrated that variations in corruption control account for economic
growth. Rich countries' economic progress is largely explained by the presence of the rule of
law.

Additional research by Acemoglu, Johnson, and Robinson (2000), Kauffman et al. (2005), Rodrik
et al. (2004), and Olson et al. (1998) has discovered evidence to support the causal relationship
between institutional quality and economic growth. In particular, they clarified that, as opposed
to the causal relationship being the opposite, a nation with stronger institutions has faster
growth.

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Furthermore, the causal relationship between institutional measures and economic growth was
examined by Chong and Calderon (2000). Between institutional quality and economic growth,
they discovered a bidirectional causal relationship. They discovered, specifically, that
institutional quality has a greater impact on economic growth in poorer countries and during
longer wait times, but that institutional quality is also a result of economic growth.

In summary, the institutional variable included in the model, the number of countries included
in the sample, the sample period considered, the estimation method used, and the type of
dataset (cross-section, time series, and panel) all affect studies on the relationship between
institutional quality and economic growth. As a result, these research' empirical findings are
inconsistent.

3.Data and Methodology

3.1 Data
We make use of a panel data set including 45 Sub Sharan African countries from 2006 to
2020.Table 1 presents descriptive data for the major factors. We make use of the six Worldwide
Governance Indicators (WGIs) developed by Kaufmann et al. (2010): government effectiveness
(GE), regulatory quality (RQ), rule of law (RL), voice and accountability (VA), political stability
and absence of violence (PV), and control of corruption (CC).

3.2 Methodology
Most empirical studies investigating the impact of fundamental factors on economic growth,
such as those by Rodrik et al. (2004), Glaeser et al. (2004), Bhattacharyya (2004), and Acemoglu
et al. (2014), utilize cross-sectional estimation techniques along with instrumental variables.
This approach offers the advantage of incorporating time-invariant factors like geography.
However, as highlighted by Lee and Kim (2009), basic OLS regression analysis may encounter
several economic issues. Factors like institutions and governance structures can be endogenous
to the dependent variable, posing challenges in traditional regression analyses.

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Additionally, both ordinary least squares (OLS) and two-stage least squares (2SLS) regression fail
to account for country-specific effects that may be associated with independent variables,
leading to omitted variable bias. To mitigate this bias, we adopt a fixed-effects panel model to
control for time-invariant heterogeneity across nations. However, endogeneity may persist even
with this approach. Therefore, to address endogeneity and heterogeneity issues
comprehensively, we employ the system generalized method of moments (GMM) approach in
our study.

Our dynamic specification is represented by the following equation:

gi𝑡 = 𝛽yi𝑡−1 + 𝜆𝑋𝑖𝑡 + 𝜇𝑖 + 𝛾𝑡 + 𝜐𝑖𝑡,…………..1

In the specified equation, 𝑔𝑖𝑡 represents the growth rate in the current period, defined as the
logarithmic difference of real GDP per capita (Δ𝑦𝑖𝑡), while 𝑦𝑖𝑡−1 corresponds to the GDP per
capita in the previous period, capturing the neoclassical hypothesis of convergence. 𝑋𝑖𝑡 is a
vector encompassing predetermined variables, such as institutional quality and human capital.
Finally, 𝜇𝑖, 𝛾𝑡, and 𝜐𝑖𝑡 denote the country-specific effect, time-specific effect, and idiosyncratic
error term, respectively. The first differences of equation (1) are obtained by applying Arellano
and Bond’s (1991) first-difference transformation.

∆𝑔𝑖𝑡 = 𝛽∆𝑦𝑖𝑡−1 + 𝜆∆𝑋𝑖𝑡 + 𝛾𝑡 + ∆𝜐𝑖𝑡…………….2

The relevant moment conditions are:

E[∆𝜐𝑖𝑡𝑦𝑖𝑡−𝑠−1] = 0 and 𝐸[∆𝜐𝑖𝑡𝑋𝑖𝑡−𝑠] = 0………..3

where t= 3,...,T, and s ≥ 1. In order to construct a system of two equations—the original level
equation (1) instrumented by lagged difference and the transformed difference equation (2)
instrumented by lagged levels—the system GMM estimator proposed by Arellano and Bover
(1995) and Blundell and Bond (1998) makes the additional assumption that first differences of
instrument variables are uncorrelated with the fixed effects.

The level equation has the following extra moment conditions:

E[(𝜇𝑖 + 𝜐𝑖𝑡)∆𝑦𝑖𝑡−𝑠] = 0 and 𝐸[(𝜇𝑖 + 𝜐𝑖𝑡)∆𝑋𝑖𝑡−𝑠] = 0……….4

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Several limitations of the first-difference GMM estimator are addressed by the system GMM
estimator (e.g., it can enhance efficiency due to the introduction of more instruments).

4.Descriptive Analysis
Table 1 Summary statistics

SSA lower Incme Uper Income Lower Middle Income

Variable Observation
Mean Observation Mean Observation
Mean Observation Mean
CC 675 0.61 326 -0.89759 90 -0.13429 285 -0.62045
GE 675 0.76 325 -1.1286 90 -0.06423 285 -0.7937
PV 675 6.04 325 -1.03039 90 0.456192 285 -0.46486
RQ 675 0.65 325 -0.97961 90 -0.03847 285 -0.71028
RL 675 0.66 325 -0.9828 90 -0.01924 285 -0.71485
VA 675 0.51 325 -0.90643 90 -0.07363 285 -0.43606
ln_gdp 675 23.08 333 22.75823 90 23.84705 285 23.2176

Data: observations from 45 Sub Sharan African countries over the period 2006-2020.

Table 1 presents descriptive statistics, including mean, for pooled observations across Sub-
Saharan African (SSA) countries categorized as upper-middle-income countries, lower-middle-
income countries, and low-income countries. The lnGDP growth rate for pooled observations in
SSA countries averages 23.08 percent. Notably, upper-middle-income countries exhibit a higher
average growth rate of 23.84 percent compared to lower-middle and low-income countries.
Government effectiveness scores average 0.76 for SSA countries, 0.06 for upper-middle-income
countries, -0.7 for lower-middle-income countries, and -1.12 for low-income countries. On
average, the political stability score is -1.03 for SSA countries.

On average, the rule of law score for SSA countries is 0.66, while it is -0.71 for lower-middle-
income countries. Upper-middle-income countries have an average score of -0.01, and low-
income countries have an average score of -0.98. Similarly, voice and accountability averaged -
0.9 for SSA countries compared to -0.07 for low-income countries. The mean control for
corruption score is 0.61 for SSA countries, -0.13 for upper-middle-income countries, and -0.89

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for low-income countries. Regulatory quality for SSA countries averaged 0.65, while upper-
middle-income countries had a mean of -0.05 and low-income countries had a mean of -0.89.

Table 2. Correlation between the WGIs.

CC GE PV RQ RL VA ln_gdp

CC 1.0000

GE 0.8506* 1.0000
0.0000

PV -0.0411 0.1532* 1.0000

0.2860 0.0001

RQ 0.7933* 0.8961* 0.2472* 1.0000

0.0000 0.0000 0.0000

RL 0.8840* 0.9136* 0.1237* 0.8909* 1.0000

0.0000 0.0000 0.0013 0.0000

VA 0.7243* 0.6805* 0.1376* 0.7268* 0.7662* 1.0000

0.0000 0.0000 0.0003 0.0000 0.0000

ln_gdp -0.1909* 0.0885* 0.6967* 0.1167* 0.0018 -0.0754 1.0000

0.0000 0.0215 0.0000 0.0024 0.9618 0.0503

In our study, we performed pairwise correlation analysis using the pwcorr command in Stata to
examine the relationships between key variables. The correlation matrix revealed statistically
significant associations between several variables. Specifically, we observed a strong positive
correlation of 0.89 between Regulatory Quality (RQ) and Government Effectiveness (GE),
indicating a robust relationship between these two factors. Furthermore, Rule of Law (RL) and
Regulatory Quality (RQ) exhibited a strong positive correlation of 0.89, while Voice and
Accountability (VA) and Control of Corruption (CC) demonstrated a moderately positive
correlation of 0.72. These findings suggest potential interdependencies among these variables,
highlighting the interconnected nature of institutional quality factors in our analysis.

5.Empirical Results and Discussion

Table 3 displays the results of econometric analysis concerning the influence of institutional
quality on economic growth within Sub-Saharan Africa (SSA). The findings from Table 3 suggest
that according to the fixed effect model, variables such as control of corruption (CC), political
stability and absence of violence (PV), government effectiveness, regulatory quality (RQ), rule of
law (RL), and voice and accountability (VA) have a positive and statistically significant impact on
economic growth in SSA. The coefficient associated with political stability and absence of
violence is found to be positive and significant §. This indicates that an increase in political
stability and a reduction in violence are associated with higher economic growth in SSA.

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Table: 3 Panel data regression
ln_gdp fixed effect Random Effect pool
CC .0035782* .0029879** .0563867*
(.0031033) (.0031107 ) (.0047989)
PV .005625** -.0059492* .0336009**
(.0024835 ) (.0024236 ) (.0032666)
GE .0083462* .0079239** .0428769**
(.004243 ) (.0041966 (.0069358)
RQ .0005439** -.0002** .0270326**
(.0044433) (.0043568 ) (.006717)
RL .0032488** .0034813** .0196265**
(.0046192) (.0046006) (.0074894)
VA .0097139* .0095207 .0024749**
(.0040512) (.0039727) (.0039108 )
_cons 22.3186 22.96364 23.38182
(.2011904) (.2923416) (.1003047)

Observations 657 657 657

Countries 45 45 45
R-squared 0.0021 0.0000 0.5837
Standard errors in parentheses ***p<0.01, ** p<0.05, * p<0.1

The estimation also tell us that having a strong rule of law is good for economic growth in Sub-
Saharan Africa. When the rule of law gets better, the economy in SSA tends to grow more.
Similarly, keeping corruption under control has a positive impact on economic growth in SSA. If
corruption is reduced, it’s likely to boost the economic performance of SSA. Another interesting
point is that the quality of regulations plays a significant role in predicting economic growth in
SSA. The results from the GMM analysis also confirm these trends.
Table 4 GMM estimation results of institutional quality and economic growth for SSA
GMM estimation results of institutional quality and economic growth for SSA
Dependent Variable: lnGDPC
Regressor Coefficient Standard Error Z P-values
Ln GDP(-1) 0.9625911 0.0499314 19.28 0.000***
Ln GDP(-2) -0.1983932 0.0622851 -3.19 0.001***
Ln GDP(-3) 0.140996 0.04213 3.35 0.001***
CC -0.0014003 0.0006598 -2.12 0.034**
GE 0.0005445 0.0007671 0.71 0.478
PV 0.000238 0.0004905 0.49 0.628
RQ 0.0008822 0.0008453 1.04 0.297
RL 0.0006835 0.0008227 0.83 0.406
VA 0.0020457 0.0007557 2.71 0.007**
Arellano–Bond test for zero autocorrelation in first-differenced errors
Order 1, p-value 0.00 Order 2,p-value 0.4759
Sargan test, p-value: [ 0.0000]

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Note: ***, **, and * denote significance level at 1%, 5% and 10% respectively

Tables 5 show how the quality of institutions affects economic growth in Sub-Saharan Africa
(SSA) and its impact on income disparities. The influence of the rule of law on economic output
varies in different regions of SSA. In higher-income countries, the relationship between voice
and accountability (VA) and output is both statistically significant and positive. However, in low-
income countries, the results suggest that voice and accountability (VA) didnot play a crucial
role in driving GDP growth. That is, for poorer countries, voice and accountability don’t have a
significant impact on economic output.
Table5: GMM estimation results of institutional quality and economic growth(three
classifications)
ln_gdp lower Incme Uper Income Lower Middle Income
Variable cofficient SD p-value cofficient SD p-value cofficient SD p-value
ln_gdp1 0.636635 0.067535 0.00 .6698617 .0597374 0.00 1.242232 0.079853 0.00
ln_gdp2 0.050601 0.054725 0.355 -0.11143 0.058588 0.057 -0.3197708 0.066208 0.00
CC -0.25151 0.122903 0.041 -0.05956 0.142449 0.676 0.0074926 0.017904 0.49
GE 0.111627 0.121666 0.359 -0.26193 0.159521 0.101 0.0230228 0.033265 0.52
PV -0.08092 0.044877 0.071 0.19359 0.059393 0.001 0.0085559 0.013217 0.22
RQ 0.03832 0.128452 0.765 -0.02548 0.078443 0.745 -0.0528969 0.043392 0.22
RL 0.22708 0.143393 0.113 0.044995 0.169318 0.79 -0.0158183 0.044265 0.72
VA 0.044702 0.081964 0.585 -0.16671 0.278484 0.549 0.0575908 0.032194 0.07
_cons 7.294205 0.926059 0.00 10.42737 1.035971 0.00 1.826429 0.54348 0.00
Note: ***, **, and * denote significance level at 1%, 5% and 10% respectively
On the other hand, the study reveals that in low-income countries, an improvement in control of corruption
(CC) is linked to an increase in economic growth, unlike the situation in higher-income countries within Sub-
Saharan Africa. Additionally, political stability and absence of violence (PV) are found to positively contribute
to economic growth in both upper and low-income countries in the region.

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6.Conclusion
The use of the System Generalized Method of Moments (GMM) estimation technique provides
robust empirical evidence supporting the relationship between institutional quality and
economic growth.
The empirical results and discussion provide valuable insights into the relationship between
institutional quality and economic growth in Sub-Saharan African (SSA) countries. The
conclusions drawn from this section include:
Institutional Quality and Economic Growth: The findings indicate that various measures of
institutional quality, such as control of corruption, political stability and absence of violence,
government effectiveness, regulatory quality, rule of law, and voice and accountability, have a
significant and positive impact on economic growth in SSA countries.
Importance of Rule of Law: The results highlight the significance of the rule of law in driving
economic growth. An improvement in the rule of law is associated with an increase in economic
performance in SSA countries.
Control of Corruption: The study reveals that enhancing control of corruption is linked to
improved economic growth in SSA countries, indicating the critical role of anti-corruption
measures in fostering economic development.
Heterogeneity in Impact: The impact of institutional quality on economic growth varies across
different income classifications within SSA countries. For instance, the influence of voice and
accountability on economic output is statistically significant for higher-income countries, while
control of corruption enhances growth in low-income countries.
In summary, the empirical results and discussion underscore the pivotal role of institutional
quality in driving economic growth in SSA countries and highlight the nuanced impact of specific
institutional measures across different income classifications. These findings have implications
for policymakers and researchers seeking to understand the dynamics of economic
development and the role of institutions in shaping growth trajectories in SSA.

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