How Much Do Institutions Matter for Trade? Evidence from Transition Countries

What is the effect of institutions on trade? A line of recent literature has observed an apparent positive correlation between measures of institutional quality and volume of trade. But this could be due to endogeneity of institutions, rather than causality. This study endogenizes institutions in estimating gravity equation for bilateral trade exploiting the differences in years under the governing system of communism as an instrumental variable for institutions. The longer a country had been under communism, the stronger might have been its institutions supporting the centrally-planned features of economy and thus, the weaker would have been their adaptability to market conditions. The reduced form equation estimates provide evidence for highly economically and statistically significant effect of the years under communism on the quality of current institutions. We find that institutions indeed have a beneficial effect on bilateral trade. However, the extent of their influence might have been misestimated while not having taken care of endogeneity. Overall, the results obtained via this approach shed a new light over the extent of explanatory power of exporter's and importer's institutions over trade that might be helpful in explaining the "missing" trade costs phenomenon having been increasingly gaining attention in recent literature on international trade. Moreover, the results suggest that the number of years under communism indirectly affected trade, pointing out at the largely objective reasons behind the differences in the amount of trade and economic success of countries of Central and Eastern Europe and Former Soviet Union on the one hand, and on the other hand, at the lasting comparative disadvantage of transition countries in general, in inheriting the institutions from the communist regime.