1          NTRODUCTION

A customary promise in politics consists of “improving the business environment” or “promoting structural reforms” to help achieve greater wealth for society. Whether these promises are held to is beyond the scope of this dissertation; however, the indicators in which those promises are measured are. Popular and easy to understand rankings such as the World Bank Doing Business report receive considerable attention from the media, eager to show which countries have fallen or risen positions, year on year . Policy makers tend to pay attention to what international organizations’ indicators: “what matters get measured – and that what we measure is what ends up mattering” said UN Women Deputy Executive Director Policy and Programme John Hendra (2014) when talking about the UN Millennium Development Goals. But can these rankings accurately measure something as subjective as business friendliness? Moreover, and perhaps more importantly, does it really matter?

Examples of countries whose leaders-proclaim that they will promote business-friendly reforms are plenty (THE ECONOMIST, 2015). India ranked 142^nd in the 2015 World Bank Doing Business Report, and its prime minister, Narendra Modi, pledged to propel it into the top 50. Rwanda, amidst plans of its president Paul Kagame to create a “Singapore of Central Africa” (THE ECONOMIST, 2012), ranked a remarkable 46^th in the same report, but remains one of the poorest countries in the world. The anecdotal evidence seems mixed and it is still unclear on what scenarios these indexes can be reliable indicators of the reality.

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I attempt to provide evidence of the effectiveness of these rankings through their effect on international trade. International trade is (perhaps surprisingly) a field that most economists agree upon and that it should be free (MANKIW, 2015). If improvements in these rankings can “lubricate” the cogs, or institutions, that also impact trade, we should expect a positive effect on welfare from this mechanism. Therefore, my specific research question is whether some of these rankings and reports influence a country’s trade flows through an empirical exploration of the gravity model of international trade.

The first hypothesis is that I will find a significant, positive interaction between a country’s exports and the quality of its institutions, these represented by a relevant indicator. This would indicate that improving the quality of institutions in a country would increase its trade flows. My second hypothesis is that these institutions interact more strongly with certain industries, and that specific indexes, when interacted with industry characteristics, will also have a positive effect on trade flows. This hypothesis stem from the fact that sectors are heterogeneous in the economy and may depend more or less on different institutions. Since the empirical results of the gravity model are well established, I expect that the refutation of the initial hypothesis would present evidence that these select indexes may not be the most adequate for guiding research and policy on the relationship between institutions and international trade. Thus, both possibilities are capable of providing meaningful results.

The dissertation relates to the articles on institutions as determinants of comparative advantage (NUNN; TREFLER, 2013) and the gravity model of trade (ANDERSON, 2010). It intends to provide a new perspective on the issue by analysing with the established methodology, models and variables of both literatures the applicability of the World Bank Doing Business indexes and some of its effects on international trade.

The rest of the dissertation is organized as follows. A background section introduces the past and current literature on the gravity model, institutions and how they relate in the field of international trade. The empirical model section details the model and data used in the empirical analysis and how it was manipulated to answer the research question. An ensuing analysis section presents the main findings and the final section summarizes the conclusions.

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2          BACKGROUND

In this section, I first lay out the fundamentals in the literature of the two main components of this dissertation, the gravity model and institutions. I progress by linking these two components and presenting some contemporary studies. Finally, I present my own model for which I gathered data and estimated.

2.1        GRAVITY MODEL

The Gravity model of trade made its debut in economic debate through the seminal works of Tinbergen (1962) and has since been used by empirical economists for analysing flows of international trade. Named after an analogy with Newton’s universal law of gravitation, the “intuitive” model states that bilateral trade flows between countries is proportional to the size of their economies and inversely proportional to the distance between them, in a similar fashion as in equation (1).

Xab=(Sizea)α∙(Sizeb)β(costsab)γ

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In which

Xabis the flow of the value of goods from country a to country b, Size measures the attracting “mass” of country a and b, costs are the total costs to trade between a and b. The main merit of the model is its strong empirical evidence. Several studies with different variables and methods find significant and consistent estimations according to the model. Even more so, the distance effect, measured as the elasticity of trade with respect to distance, is stable across numerous studies and is consistently around -1, at least since the 1970s (DISDIER; HEAD, 2008). The practical assumption was then is that distance increases transportation costs, and that transportation costs raise the price of the good in the importing country, leading to less trade.

One of the most fascinating debates derived from these empirical studies are the costs of national borders to trade, as initially shown in the United States-Canada border effects by McCallum (1995). His study showed that these two relatively similar countries in regards to culture, language and colonial origins, but separated by a border, can have vast differences from what a standard gravity model would predict in a borderless scenario. More specifically, he estimated that the trade flow amongst Canadian provinces is more than 22 times larger than the trade flow from a Canadian province to an American state. This showed compelling evidence against the widespread beliefs that globalization was making borders trivial, thus qualifying the effects of free trade agreements and economic integration processes and adding to contemporary debate.

These findings, however, lacked strong foundation in economic theory, raising questions about its validity. Its constant regularity seem to indicate there must be an underlying economic relation behind it, yet there was no consensus for the gravity model theoretical underpinnings. Anderson (1979) attempts to explain the phenomenon by deriving the gravity model from a Cobb-Douglas and a, in the appendix, a constant elasticity of substitution (CES) demand function, both in which countries produce and sell goods to other countries that are differentiated from the goods produced by the other countries. However, it had several limitations and did not fully explain the findings of the model.

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It is only later that Anderson and Van Wincoop, (2003) elaborate the model that has become the benchmark for gravity analysis. They expand on Anderson’s CES model by showing that the flow of bilateral trade is affected by both the trade costs at the bilateral level (bilateral resistance) and the weight of these costs relative to all other countries (multilateral resistance). Their structural gravity model in a multi sector economy is represented by

Xijk=EikYikYktijkΠikPjk1-σk

Πik1-σk=∑jtijkPjk1-σkEjkYk

Pjk1-σk=∑itijkΠik1-σkYikYk

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Where

Xijkis the flow of exports from country i to country j in product k,

Yikand

Eikare the value of production and expenditure in country I for product k,

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Ykis the world output in sector k,

tijkare the trade costs of exporting a product k from country I to j and

σkis the elasticity of substitution among products.

Πikand

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Pjkare the outward and inward multilateral resistances, respectively.

Intuitively, equation XX can be seen as two different parts: the left side of the equation or the “mass” term and the right side of the equation or the “cost” term. The mass term is the hypothetical level of frictionless trade between two partners in the absence of trade costs. In the overall equation, it means that large industries export more to the whole world, as large markets import from the whole world (ANDERSON, 2010). The cost term represents the trade costs that create the discrepancies between expected and actual trade. It is composed by the bilateral trade cost between partners I and j (traditionally estimated through geographic, political and policy variables), the outward multilateral resistance (country I ease of export) and the inward multilateral resistance (country j ease of import).

The main merits of this model is that it shows that changes in trade costs of one bilateral trade route influence the trade flows on the other trade routes because of relative prices. Since these resistances are by definition correlated with trade costs, so it improves on the basic intuitive model by eliminating the omitted variable bias that arises when failing to account for them. It is an empirical estimation of this model that the authors dispute about the magnitude of the border effects found by McCallum. Although their estimates were not as high, they nevertheless found a “border effect” between Canada and the United States that caused a reduction of 44% in trade flows.

In order to make it possible to estimate such a model, approaches in the literature (SHEPHERD, 2013) suggest using a fixed effects model transformation from equation XX

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log⁡Xijk=log⁡Yik+log⁡Ejk-logYk+(1-σ)[log⁡tijk-log⁡Πik-log⁡Pjk]

To the equations XX:

log⁡Xijk=Ck+Fik+Fjk+1-σklog⁡tijk

Ck= -log⁡Yk

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Fik=log⁡Yik-log⁡Πik

Fjk= log⁡Yjk-log⁡Pjk

Where

Ckis the constant that applies for all countries and is used as the proxy for the effect of the world’s production in sector k. The remaining terms are the exporter-sector and importer-sector fixed effects.

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Other have also derived the gravity model from standard trade theory. Helpman et al. (2008) and Bergstrand (1985) presented a models of the gravity equation based on the assumption that firms are heterogenous in productivity. Deardoff (1998) derived the model based on the Hecksher-Ohlin model of international trade, in which countries have different factor endowments, and Eaton and Kortum (2002) derived the model out of the Ricardian model, in which countries vary in technology. While these models have their merits, I focus on that from Anderson and Van Wincoop (2003) because of its simplicity and its ease of estimation.

Most of the literature consist of trying to devise better estimates for the trade costs. These have been subject of much study since Linnemann (1966) categorized them into shipping costs, time-related costs and cultural unfamiliarity, this last being of particular importance. Anderson and Van Wincoop (2004) show through empirical observations using their model that several variables have a significant effect on trade through the increase or decrease of trade costs and that are well beyond those variables that are observable.

Shipping costs are the most apparent; its weight in the final cost of exported goods vary a great deal according to the distance of the two countries and the nature of the goods being transported[1]. Anecdotally, it should not be a surprise that it costs less to export jewellery from Switzerland to Germany than it does to export coal from Australia to the United Kingdom. These costs have fallen significantly in the era of globalization mainly due to technological changes, such as the containerization and jet aircraft engines, and economies of scale in the shipping industry (HUMMELS, 2007).

Time-related costs are relevant because of the time value of the money, the perishability of products and the constraints of a significant lag between ordering a shipment and receiving the products, all of which can affect a firm’s to export or import. Payment terms to the importer can range from full payment before production to full payment several months after the shipment, depending on the assessment of risk of the transaction by the partners. Products such as fresh fruit or flowers require complex coordination so they can reach their markets when they are the most adequate for consumption. Finally, some industries, such as fashion retailing, may see the boom and the bust of a trend in less time than it takes a cargo freighter to arrive from the traditional producers in Asia.

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The cultural unfamiliarity costs present a different challenge, as they are not as easily observable as shipping costs or time related costs. A more intuitive systematization of such costs is the CAGE distance framework by Ghemawat (2001) and presented in Table 1. The framework lists the cultural, administrative, geographic and economic differences among countries. Intended as a guide for companies interacting with foreign markets, it nevertheless succeeds in systematizing the variables of interest for calculating the trade costs across countries, many of which have been empirically tested before and after its inception.

Table 1 – CAGE distance framework