Foreign determinants of local institutions: Spatial dependence and openness

There are both empirical and theoretical arguments for the thesis that foreign factors have an impact on domestic institutional quality. Yet the literature is divided over whether exposure (openness to the world economy) or the kind of institutions in surrounding countries (relative location) determines the quality of local institutions. This paper confronts these hypotheses empirically, addressing the issues of strong cross-sectional dependence and the endogeneity of openness. In a 107-country cross-section, both trade openness and relative location have a positive impact on local institutions. The institutional quality of neighbouring countries is not found to be statistically significant when considering openness to foreign direct investments instead of trade, but the statistical performance of that model is poorer.

► Does trade openness or foreign institutional quality explain local institutions? ► Addressing endogeneity issues and cross-sectional dependence, both explanations hold. ► The indirect effects of trade openness may be as large as the direct effects. ► Openness to FDI renders the institutional quality of nearby countries insignificant.