Institutional Environment and Growth in Brazil

Economists have long used a variety of approaches to shed light on why some countries experience faster growth than others. In the vast amount of literature on the subject there are three schools that stand out in particular. First, there is a group of scholars that places geographical factors such as climate, transport cost and natural resources as the main explanatory factors. Recent writings by Jarred Diamond and Jeffery Sacks are important contributions in this paradigm (Diamond, 1997; Sacks, 2001). Second, there is a faction that emphasizes international trade as a key to economic growth.

Important contributions to this market-integration view have been presented in the arks of Franken & Roomer (1999) and Dollar & Kraal (2004). Finally, there is a third group focusing on the explanatory power that institutions veil in this matter. This paper will follow in this tradition, as there seems to bee an increasingly pervasive concurrence among economists studying the phenomena that the development and quality of the institutional environment holds the key to prevailing patterns of sustained growth and prosperity around the world.

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Rich countries are those with sustained rule of law and property rights, effective policies towards private enterprises and intention, the political system is stabile and effective, companies enjoys easy access to financing and superior tax regimes and there is a well functioning infrastructural system. Poor countries are those where the arrangements are nonexistent or ill formed. This approach suggests a somewhat casual relationship between institutional development and economic growth.

This implies that a poor country, which is able to revise the rules of the game in the direction of better institutional environment, is likely to experience a lasting economic growth. The causality f this relationship has however been questioned (Rod, 2004; Houseman et al, Bibb). In this article we want to investigate the relationship between institutional development and economic growth further in order to enhance the understanding of the relationship.

Is this really the end of all policy development and a manifestation of an “institutions rule” approach to economic development? Long run trends in the global economy suggest that emerging markets are the new drivers for global economic growth. Emerging markets can be defined as countries with lower level of development than DEED, North America ND Japan and high growth in recent years (Mining, 2007). This makes emerging markets countries useable as laboratories for trend research related to economic growth.

Brazil, as a part of the BRICK countries, has for a long time been defined as an emerging market country’. In spite of quite impressive reforms (Houseman et al, Bibb) the country has failed to show similar growth rates as China and India (DB, 2008). In this paper we therefore want to investigate how the economic growth in Brazil is related to the development in the institutional environment. Could the development and laity of the institutional environment in Brazil hold the key to understanding how to increase growth in the country?

These notions has led to our research question, which is: How does the institutional environment affect the economic growth in Brazil? The deductive model In order to answer our research question we will apply the traditional deductive method of conducting research. First, we consider at a theoretical level the relationship between institutions and economic growth. Second, we build hypotheses on the basis of our theoretical framework. Third, we apply it to data. Finally, we deduct from the study. Our approach emphasizes quantitative data and is highly formalized.

In this paper we will use the deductive model as proposed by Seekers (1992). The model has 8 steps as illustrated below and largely corresponds to the structure of the paper. The steps are shown I a linear fashion, but in the reality the process is more dynamic. Literature review The concept of institutions and its influence on economic growth can be traced back to the functionalist perspective, which draws upon the ideas of August comet (1852), Herbert Spencer (1851) and ?mile Druthers (1893).

The functionalist approach is centered upon the argument that, if society is to exist, its members must make provision for certain functional requirements. Institutions are the principal structures where these critical tasks for social living are organized, directed and executed (Hughes et al. 2002). Institutions have been studied from several viewpoints and disciplines ranging from sociology, organizational psychology, to new institutional economics originating from the learning of transaction cost economics.

In this paper we will follow the new institutional economic approach. The transaction cost view on organizations can be divided into two groups. First, motivation cost, which deals particularly with costs of opportunistic behavior and agency cost (Williamson, 1975, Jensen and Neckline, 1976) Second, coordination cost, which deals with costs of information, costs of coordination and costs of measurement (Stiller, 1961, Lucian and Demesne, 1972).

With a well-working interface transfers occur smoothly, but sometimes the transaction encounters friction due to conflicts between the parties involved. This friction can lead to delays, breakdowns and other malfunctions ND is in economics termed transaction cost. The new institutional economic approach argues that all human interaction is characterized by a high degree of uncertainty (North, 1990). Institutions are therefore a way of reducing uncertainty and thereby transaction costs of trade.

Furthermore, institutions are, as an extension of motivation cost theory, created by people with different bargaining power and not for the sake of efficiency, which makes some more efficient than others. Inefficient institutions can result in stagnant economies due to path dependency, which an lead to the lack of acknowledgement of property rights by states. Such environments can lead increased transaction cost and diminish the incentives to invest in socially profitable businesses. North therefore argue that the key to economic growth is efficient property rights, which moreover depends on political efficiency.

In Institutions (1991) North, focuses further upon three elements of transaction cost: measurement cost, level of acclimatization and the amount of bargaining at the margin. It appears, however, that North have found a simplification and new applicability for these theories on state owned institutions and its relation to economic growth. Even though no clear-cut distinction exists between institutions and organizations, we have chosen to adapt North’s (1991 ) definition Of institutions as ‘the rules Of the game” and organizations as the different players.

Further we adapt a sociological view on actions in markets, which conceptualizes Eighteen’s institutional framework related to the relationship between state and firms in the development of an economy. His main findings relate to how “politics in markets work during various stages of market development-formation, stability and transformation” (Flintiest 996:656). As result we move away from the traditional institutional sociology of the early social scientists such as Selenium (1946) and later, DiMaggio and Powell (1991), and Scott (1 995), and moves toward economic institutionalism.

The main point however, is that we adapt an understanding of how modern states must create an institutional framework for a well functioning business system, and as such institutions are necessary as preconditions for economic growth. Theoretical framework and generation of hypothesis Inspired by North and Flintiness definitions of institutions, we assume that impasses cannot Operate in a Brazil without collective Sets Of rules and governing interaction. In order to achieve economic growth Brazil must therefore create an institutional framework, which supports the economic actors.

Further the institutions in Brazil must structure political, economic and social interaction and set up norms. Our central hypothesis is therefore that the stage of development of the institutional environment in Brazil is crucial in order to develop sustainable economic growth, by reducing transaction cost of doing business and thus establish incentives faced by economic actors. Hypothesis 1 . The level of economic growth in Brazil is dependent on the Stage Of development in the institutional environment.

There is strong empirical support for the proposition that institution matter (Franken & Roomer, 1 999; Guacamole et al, 2001 One example of this is presented in the paper “Institutions rule” (Rod et al. 2004) which explores the relationship between integration, institutions and geography with income. The findings show that the quality of institutions is more important than any others factors related to income levels. There is however little agreement on heir relative importance and the causality of the link when it comes to increase economic growth.

In the voluminous literature on this subject, there are several failed attempts to discover unique institutional designs with encountering effective institutional outcomes. (Houseman et al. AAA), Since there are strong arguments favoring that there is no unique mapping from function to form “… It is futile to kick for encountering empirical regularities that link specific legal rules to economic outcomes. What works will depend on local constraints and opportunities. (Rod, 2004:9) The aim of this paper s therefore to come up with contingent correlations or institutional prescription that are limited to the prevailing characteristics of Brazil. We thus try to extend the previous literature by exploring the development of the different elements of the institutional environment in order to discover which institutions that have been crucial for the economic growth in the case of Brazil. In order to investigate the relative importance of the different institution in Brazil it is necessary to define more precisely what the institutional environment consists of.

Traditionally the institutional environment in a entry is made up of and measured by the ability to make “investors feel secure about their property rights, the rule of law prevails, private incentives are aligned with social objectives, monetary and fiscal policies are grounded in solid macroeconomic institutions, idiosyncratic risks are appropriately mediated through social insurance, and citizens have recourse to civil liberties and political representation” (Rod, 2004) To separate and distinguish between the institutional factors We adapt the institutional framework presented in John Dining’s “Institutional reform, foreign direct investment, ND European transition economies” (Dunning, 2005) and “Foreign Investment location and institutional development in transition economies” (Bean et. Al, 2006). These papers have developed an institutional framework consisting of three generic groups of variables namely: policy framework, economic determinants and business facilitation’s.

The three groups should be viewed as “institutional spheres” containing institutionally related determinants, which all aims at reducing transaction cost in Brazil and thus establish incentives faced by economic actors. First, the policy framework addresses institutionally related determinants that re under directly control of the government in Brazil. This is arguably the most important institutional sphere as it covers central aspects of institutions such as the rule of law and enhancement of property rights (North, 1991). It consists of institutions that provide economic and political stability, international agreements on FDA and taxes (Dunning, 2005), monetary and fiscal polices (Rod, 2004) and rules regarding competition (Flintiest, 1996).

There are strong theoretical and empirical evidence connecting these institutions with transaction cost, thus we hypothesis that a positive velveteen in the policy framework will result in a positive development In the economic growth in Brazil. Hypothesis AAA – The level of economic growth in Brazil is dependent on the Stage Of development in the policy framework Second, the economic determinants cover institutions related to market opportunities, resource endowment and the availability and cost of labor (Dunning, 2005). It can be argued that these determinants depend on the underlying incentive structure and enforcement procedures, but if the institutional system in Brazil fails to provide the economic actors with lifted labor and necessary resources transaction cost will go up.

Another aspect which gives support for this argument is that a well developed infrastructure eases the means of communication and therefore eliminates and lowers, spatial transaction cost (Dunning, 2005). Thus, we propose that an increasing quality in the economic determinants of Brazil will result in a positive development in economic growth Hypothesis b – The level of economic growth in Brazil is dependent on the stage of development in the economic determinants Third, there are strong arguments in favor of the notion that business- acclimating institutions such as the bank systems and other finance institutions also play an important role for the economic growth in Brazil.

This because “progress in establishing financial infrastructure and capital markets reduces transaction costs for Brazilian financial services, such as the payment system. “(Bean et al, 2006) In addition customers have easier access to bank credit, which again can increase the demand for consumer goods that often are bought on credit (Bean et al, 2006). Moreover, it facilitates access to complementary local finance, which can reduce investor’s exposure to exchange rate risk. Institutions related to infrastructural support service and a well function banking and financing system are thus necessary in the establishment of incentives for economic actors in Brazil. Hypothesis c – The level of economic growth in Brazil is dependent on the stage of development in business facilitation Tidbit 1.

I Hypothesis, construct and measurement I Hypothesis Construct Data source I (appendix 1) II environment rating (1 0=high) development I Predicted effects Variable definition I Institutional I Overall business ELLS 2008 (Unsighted average) I Policy dating (1 a-?high) I Political environment Ell] 2008 Scientific Research Design 1 Methods of empirical analysis GAP is a commonly used indicator for economic growth and our analysis is based upon a dataset consisting of the percentage change in real GAP, over previous year (% real change pa) figures in Brazil from 1 995 to 2007 and GAP (% real change pa) estimates from 2007-2012 (XIII). In order to explore any relationships between our selected variables and GAP (% real change pa) a regression model will be built. LEN GAP real change pa) -? boo+ bal Real effective exchange rate (ICP- eased) + be overall business environment rating+ The precise definition, form and source of the variables used in our analysis are presented in table 1 , which also summarizes the predicted effects of each independent variable on GAP in Brazil. All possible significant combinations will be evaluated including isolating each single variable against the dependent variable in order to identify any possible relationship.

The descriptive statistics of each variable are presented in the appendix 2, 2 Construct measurement of independent variables Our measure of development in the overall institutional environment that IS seed to test hypothesis 1 is based on an aggregate of series of indicators of institutional quality constructed by the Economist Intelligence Unit (ELLS). The framework I Tax regime rating (10=good) I XIII 2008 policy towards private enterprise rating (10=good) I III_J 2008 bib 1+ I EIA 2008 Macroeconomic environment rating (1 0=high) exchange regime rating (10=good) Foreign trade and JUICE 2008 I Policy environment for foreign investment rating (10=good) determinants I + I 2008 I Economic SEIZE 2008 2008 I Eli-1 2008 I Market opportunities rating (10=high) I Labor market rating

I ELLI 2008 Infrastructure rating (1 0=good) Business facilitation 1+ I Ell-J 2008 Real effective exchange rate (ICP-based) I Financing rating XIII has constructed and Business Environmental Index derived from ten broad determinants of institutional quality. These determinants are essentially a composite of data and opinions taken from a series of business surveys conducted by XIII it self. Each of these determinants is reported on a I-ID scale with higher numbers indicating a more business friendly institutional environment. For the next propositions, we employ the indices separately. The survey has a time span from 1995 to 2012 and consists of 13 variables each consisting of 15 observations. From 2007 and beyond are estimate. For the next hypothesis we employ the variables individually.

Presentation of results Tibiae I Correlation independent variables and GAP (% real change pa) Significance development I Institutional 1. 110 Overall business I policy . 183 rating (1 0=high) Policy towards private | . 263 . 080 exchange regime rating (10-?good) I Foreign trade and determinants + . 249 | . 392 I Market opportunities rating (10-?high) | . 220 ICC . 112 Infrastructure rating (1 a-?good) . 126 I Financing rating (10=good) I Real effective exchange rate (Cap-based) Discussion of results ;100 It is difficult proving a statistical meaningful relationship based on econometric tool between institutions and GAP. There are some general problems to our model that could be accounted for statistically that are beyond the scope of this paper.

This is especially related to the validity of the model where the sample size is problematic. Additionally, the reverse correlation between the variables (nonentity) also plays an important role. The scope Of the study should also be taken into consideration, which makes t difficult to infer about this more complex relationship. Here we could be discussing a selection bias, both country and respondent and variable specific. This is a threat to the valid estimation of the general causality between the dependent and the independent variables. It is also known that there is a relationship between these institutional based on former studies of institutional economics (North 1990; North, 1991; Flintiest 1996; Mining 2007).

In regards to the validity, construct validity could be discussed in this case, as it is based on interpretation of institutions. Furthermore, the interaction of election, related to the explanatory variables could bias this study and how the respondents and their responses are correlated with institutions. Nonetheless, the limited time span of the study could be further discussed but more pressuring is history bias and whether other exogenous factors affecting the independent variable, could impact the model, as this could easily be thought to be the case in Brazil. Moreover, we do not know the design of the data gathering process, which could include instrumentation bias.

Referring to questions formulation and what is measured, there might also be considerable hypothesis guessing. Referring to the fact that ELLS respondents could be answering questions in regards to their conception, rather than the measurement purpose. This is threatening the external validity, nonetheless the internal consistency of the questions is also an issue as questions could be overlapping. In line with conclusions from previous studies done on this subject, as a determinant for why econometric models are difficult or lacking in explanation (Houseman, Bibb; Rod, 2004). Tests often imply the interdependence between institutional predictors, which makes it hard to distinguish between the institutional dynamics and economic environment.

Rod (2004) is especially critical to this and he has addressed a very central point, which is also relevant to this study, arguing that investors often rate institutional quality high when the economy is doing well. Thereby creating causation that would only be perception based. Whether it is effects of institutions that are measured the causation will still be evident. Furthermore, the nonentity with GAP, makes it a complex web that needs to be dismantled before meaningful results can be given, if possible at all with this type of study. Additionally, effects of institutions are a deter estimator rather than framed proxies, consistent with argumentation in (Houseman et al, 2005).

The explanation could also be that there is interdependency between different institutional parameters, which is evident from previous research. But how much is related to actual correlation between variables and how much is related to measurement difficulties will also be an issue to the validity of this paper. Nonetheless, the meaning derived from this Of experiment. An additional explanation for why the explanatory power of our econometrics is limited as they often point in the sight direction but needs to be explored further. (Houseman et al, Bibb) Moreover, policy effects are often visible on a long-term basis and are often identified ex-ante rather than ex-post. (Redbrick, 2004).

This relates to the aspect of data-lags also being a subject to the validity as institutional improvements in a country do not always go hand in hand, the visible results could be shown later, emphasizing difficulties capturing this relationship in any meaningful way. In addition, we do not know if GAP improvements occur because of institutional improvements or the other way around (Rod, 2004). Bowwow’s and Collins (2003) have statistically tested aspects of institutional theory, and found a correlation between growth and the quality of governing institutions, “such as law and order, absence of corruption, and protection of property rights” (Bowwow’s & Collins 2003). However, the link is not always apparent and institutional quality should be stressed in this context.

But other factors relating to the second best theories also play an important role in a more dynamic Context such as “Business sectors, information spillovers, Human Capital” (Houseman et al, AAA) Furthermore, it is still important to kook at institutions in a country specific perspective as differences in geography, factor abundance and, governance structure and linkages. (Houseman et al, AAA) These factors differ from country to country even though economic growth is related to institutions. Econometric cross sectional analysis as a tool to reach an ultimate conclusion on the causes for growth, is therefore problematic. The link between the second best interactions viewed very simplistically IS government interactions and reforms.

These are difficult to measure and identify, however, the impact of reforms can be reasonably estimated. Reforms do not always live up to the purpose as it should be the right reforms suitable for the circumstances. (Houseman et al, 2005). Validity issues discussed above are rampant in our model, which pose a threat to the reliability of the model. Many models have been built to demonstrate the relationship between institutional environments.

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