Tag: Institutions

Environmental Enforcement in the EU: Insights from Administrative Cases in the US

Posted on May 23, 2023 | Policy Brief

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In March 2023, the European Parliament’s legal affairs committee voted unanimously in favor of a proposed update to the EU Directive on environmental crimes (Directive 2008/99/EC). The update seeks to step up enforcement of environmental legislation across Members States through criminal law aimed at severely punishing very serious environmental offenses. We argue that, while laudable in its goal of strengthening enforcement of environmental regulation at the EU level, the current effort might be insufficient since moderately serious offenses might remain largely unpunished. To address this shortcoming, we propose harmonizing administrative law as well. We consider additional benefits from relying on administrative law in terms of flexibility of punishment design, based on the US experience of using environmentally beneficial projects performed in affected areas as a form of punishment in administrative environmental settlements. We discuss evidence on the merits and potential limitations of the US approach based on Campa and Muehlenbachs (2022) and conclude that such an approach is worth considering in the EU context.

While the EU has set aggressive pollution reduction targets across its Member States (European Commission, 2021a), for example pledging to reduce deaths due to particulate matters to 55 percent of 2005 levels by 2030 (European Commission, 2023a), much work remains to be done. As documented in Lehne (2021), in 2020 all countries in Europe reported PM2.5 concentrations above the World Health Organization (WHO) guideline of 5mg/m3. Six countries, including three EU Member States (Italy, Croatia, and Poland) reported levels above the EU’s annual limit value of 25mg/m3. Further, Bulgaria, Poland, Portugal, Croatia, and Romania did not meet national targets for PM2.5 reduction (European Environment Agency, 2023). Main contributors to PM2.5 pollution are transportation and industrial activity, including energy production. High concentrations of these particles are known to increase physical and mental health risks (Persico, 2022; Persico et al., 2016), and risk of premature deaths (Fuller et al., 2022).

Environmental concerns across EU Member States are also not limited to air pollution. Across the EU, 28 percent of groundwater sources are affected by pollution from agriculture, 14 percent from industrial contamination, and 7.5 percent from mining waste (Kampa et al., 2021). The persistent pollution problems in the EU and their unequal distribution across regions despite growing EU-level environmental legislation underscores the importance of law enforcement. While all EU Member States are theoretically subject to the same overarching environmental standards and regulations, the enforcement of environmental laws differs widely across countries. To address this issue, the EU Commission (henceforth EC) has recently taken steps to further harmonize environmental enforcement across EU Member States.

In this brief we consider the EC’s proposal and argue that, while commendable in the goal of strengthening enforcement of environmental regulation at the EU level, it is also quite limited in terms of enforcement tools that it considers. Specifically, we discuss potential advantages of leveraging administrative law tools to enforce environmental regulation, whereas the EC approach is currently focused on criminal law. We consider the higher probability of prosecution and the enhanced flexibility in the type of penalties allowed by administrative enforcement actions. Finally, we discuss results from Campa and Muehlenbachs (2022), which studies the use of administrative penalties for environmental violations in the US and draws some lessons for environmental enforcement in other jurisdictions.

Strengthening Environmental Enforcement at the EU Level

While environmental regulation is a shared competence of the EU, enforcement has historically been left to national environmental authorities (European Parliament, 2016). In the face of a lack of institutional capacity at the national level, a result of this arrangement are generally low levels of environmental enforcement, widely heterogeneous across Member States (Mazur, 2011). EU institutions have tried unsuccessfully over time to address this challenge and harmonize enforcement across EU Member States. An early attempt was made in 2001, when the EU put in place minimum standards for environmental inspections that Member States carry out, though these were only non-binding guidelines, and Member States could not be sanctioned for flouting them (European Parliament, 2001). Mandatory standards were then introduced in 2008, with the EU Directive on environmental crimes (Directive 2008/99/EC), which forced national governments to apply criminal sanctions to those causing “substantial damage” to the environment. However, it has typically been difficult for the EC to sanction non-abiding Member States. Moreover, the obligation is limited to areas where the EU has competence and does not include minimum penalties.

In another attempt to step up their enforcement efforts, in 2016 the EC began publishing the annual Environmental Implementation Review, where each country is evaluated on its environmental affairs and enforcement (European Commission, 2023b). Although this does not improve the EC’s ability to efficiently sanction Member States, it does increase scrutiny and visibility. In 2021, the EC tabled a proposal to update the 2008 Directive on environmental crimes (European Commission, 2021b). The proposal acknowledged the insufficient number of environmental criminal cases successfully investigated and prosecuted as well as the large discrepancies in the transposition of the 2008 Directive across Member States. Against this background, the EC proposed to enlarge the scope of the 2008 Directive, establish minimum penalties, foster cross-border investigation and prosecution, and promote data collection and dissemination on criminal enforcement actions. In March 2023, the European Parliament’s legal affairs committee voted in support of the EC proposal, extending the list of offenses that would be criminally charged and increasing the size of the minimum penalties.

Environmental Enforcement, Administrative Law and “In-kind” Punishment

The efforts of EU institutions to improve and harmonize enforcement are exclusively focused on criminal law instruments. The EC’s 2021 proposal specifically links poor enforcement in Member States to their reliance on administrative law, which limits fines and thus allegedly reduces the deterrence value of enforcement actions. Indeed, sufficiently high fines are considered crucial to deter future violations (see, e.g., Aguzzoni et al., 2013). However, we argue that reliance on administrative law also has some advantages. In particular, we consider two potential benefits of administrative law based on existing studies, namely higher probability of case initiation and more flexibility in terms of penalty design.

Probability of Case Initiation

One of the shortcomings of the current enforcement framework highlighted by the EC is the very low number of environmental criminal cases that are ultimately prosecuted. Research on enforcement tends to link the low frequency of observed criminal cases to the high cost of criminal proceedings, especially relative to more informal administrative procedures (Faure and Svatikova, 2012). The cost dimension is especially relevant for cases that are moderately serious, but that nevertheless in aggregate contribute significantly to environmental degradation. The probability of catching violations is also relevant, together with the size of the penalty. A very large penalty for a criminal case that is highly unlikely to be prosecuted might be less deterring than a moderate penalty associated with very high probability of prosecution.

“In-kind” Penalties

Federal environmental regulations in the US are enforced through a combination of administrative and criminal law. The Environmental Protection Agency (EPA) initiates administrative cases or refers them to the Department of Justice when the gravity of the violation is large. Administrative cases result in settlements where the defendant can be ordered to pay a fine, which can vary from a few thousand to a few million dollars and which is determined according to various factors, such as the magnitude of environmental harm, the firm’s economic gain from violation, its violation history, and its ability to pay. Additionally, when a fine is established, defendants are given the opportunity to volunteer to pay for an environmentally beneficial project in the affected area. The EPA encourages these projects especially in areas subject to environmental justice concerns, namely those characterized by a large share of minority and low-income households.

Campa and Muehlenbachs (2022) study the implications of using these projects in environmental enforcement cases in the US. The study reveals a large preference among the public for this “in-kind” form of penalty versus traditional fines, based on a survey of US residents. Moreover, a randomized survey experiment reveals that these environmental projects elevate the profile of the firm among the public as compared to a firm that only pays a fine, even when the penalties stem from the same violation. Similarly, the stock-market response to the announcement of these projects is positive, whereas announcing a settlement with a large penalty causes a drop in the stock-market price of the defendant. In terms of implications for environmental justice, the data analysis shows that the whitest and richest communities are the most likely to receive these projects, but the second largest share goes to communities where there are highest concentrations of minorities and low-income households.

Overall, the study finds that punishing firms through environmental projects can be beneficial for political economy reasons, given the large preference for this enforcement tool among the public and likely among firms, since firms seem to benefit from undertaking the projects. Moreover, while the targeting of environmental justice communities in the US is not perfect, tweaking the US arrangement could guarantee that the projects predominantly benefit those communities most harmed by environmental violations.

For EU adoption of environmental projects enforcement, a caveat is that the perception of these projects might be different among the public in the EU. Nonetheless, large-scale surveys modelled on those presented in Campa and Muehlenbachs (2022) can help in understanding public views in different regions. Moreover, the paper emphasizes that on the one hand, by benefiting defendants, the environmental projects might ultimately be a more lenient punishment than fines, with implications for deterrence and future environmental quality. On the other hand, environmental quality might also improve as a direct effect of the projects being implemented and due to improved monitoring in affected communities (Dimitri et al., 2006). Overall, the study finds that future environmental quality might be more likely to improve following fines rather than environmental projects. However, it cautions the reader on data limitations that causes the result to not be conclusive enough and calls for further research.

Conclusion

The persistence of environmental problems in the EU, as well as the striking differences in pollution levels across EU Member States, underscores the need for more and better environmental regulation. However, even in the presence of comprehensive and strict environmental rules, the protection of the environment is still inadequate if a proper enforcement mechanism is not in place. As observed in OECD (2009), proper enforcement ensures deterrence. Successful deterrence provides the best protection for the environment, while reducing the resources necessary to administer laws by addressing non-compliance before it occurs. EU institutions have recently taken important steps to improve and further harmonize enforcement of environmental regulation across Member States, with proposed updates to the existing Directive on the matter scheduled for Member-State discussion in upcoming months.

Specifically, the EU is seeking to step up the use of criminal law to prosecute environmental offenses across Member States, with mandatory penalties and increased cross-border coordination. We argue that the focus on criminal law has some drawbacks, which could be addressed by also harmonizing administrative enforcement across EU Member States. Researchers have previously argued that reliance on administrative law might increase the likelihood that offenses are investigated and prosecuted. We also present evidence from the use of administrative law in the US, where defendants in environmental cases can settle to pay part of their penalty “in-kind”, i.e. by performing environmental projects in areas affected by the alleged violations. The evidence suggests that the use of these projects is worth considering in other jurisdictions, including the EU, because they might be preferred by the public and could help addressing environmental justice concerns. An important caveat is that their implications for environmental protection are not clear, and more research should address this important aspect. On the subject, the existing evidence on environmental enforcement in the US, such as that presented in Campa and Muehlenbachs (2022), is established thanks to the availability of rich data sources kept by the US’ EPA. The EC’s recent proposal to systematically collect and disseminate data on environmental crimes is thus particularly welcome and should not be overlooked in the upcoming negotiations with Member States on the final content of the proposed Directive.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

On Corporate Wrongdoing in Europe and Its Enablers

Posted on April 13, 2021 | Policy Brief

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In the last two decades, several instances of prolonged and severe corporate wrongdoing by European companies have come to light: from Dieselgate to corruption, money laundering through large European banks, recidivist bid and price rigging, and most recently Wirecard. What allowed European firms to engage in so much wrongdoing? In this brief, we consider some important institutional drivers behind corporate wrongdoing, focusing on the European countries with the largest share of corporate infringers.

The Harm from and Extent of Corporate Wrongdoing in the EU

In June 2020, the German firm Wirecard AG’s stock price fell from €104 to below €2 in the span of nine days after the firm admitted it could not locate $2 billion missing from its accounts. The firm has since then been accused of a wide range of infringements including money laundering, corruption, and fraudulent inflation of profits and sales, with some allegations going back over a decade. The Germany financial supervisor BaFin has been criticized as allegations about fraud had been made several times in prior years. Yet, BaFin failed to identify the problem and even banned short-selling of the stock, as well as accused journalists who were critical of the firm of market manipulation.

This scandal occurred against a backdrop of several other prolonged corporate scandals and has led many to wonder how extensive corporate wrongdoing is and how to combat it more effectively.

Corporate wrongdoing has a range of negative effects in competitive markets that are frequently overlooked in the public debate. Beyond the immediate damages of corporate wrongdoing, such as the draining of public resources in the case of tax evasion, money laundering, corruption, air pollution and associated health harm in the case of environmental law violations, there are also more general negative effects of corporate wrongdoing.

It attracts investors to the worst part of the industry, as firms that engage in profitable wrongdoing often do better than their competitors. Also, it forces out honest competitors and increases market entry thresholds for new competitors. These effects become more pronounced when the wrongdoing is prolonged, so, in an ideal world, regulators need to act fast.

Instead, several recent cases of European corporate wrongdoing lasted for many years before being detected and sanctioned, and there is a worrying degree of recidivism in several regulatory areas, including financial regulation with several banks being recidivists, but also in antitrust (Marvão, 2016).

What are the drivers and enablers behind these many prolonged cases of wrongdoing, and why do firms feel emboldened to engage in recidivism?

One way to gain some insight is to identify European countries whose firms are most frequently fined for wrongdoing and review the legal, cultural, and political contexts of those countries.

We tackle this issue by using data from Violationtracker, a database with over 400 000 actions by US enforcement agencies and prosecutors (such as the Securities and Exchange Commission and the Department of Justice). Many of these sanctions are against firms with headquarters in EU countries. In Nyreröd and Spagnolo (2021a), we added the fines for firms with headquarters in all respective EU countries for the period 2000-2020. After excluding countries like Switzerland, well known as homes of extensive financial crime linked to their status of international tax havens and off-shore centers, we find that the United Kingdom is the gold medalist in corporate wrongdoing, with Germany coming in second place.

Table 1. Fines across the top six EU countries (2000-2020).

Note: Author’s calculation based on data retrieved from Violationtracker.org. Number of fines in parentheses.

Interestingly, the top of the ranking is preserved no matter which metrics we use. In Nyreröd and Spagnolo (2021a) we weigh the fines by population, GDP, and exports to the US, and the UK and Germany remain stable at the top, with the UK’s first position becoming more pronounced. Therefore, we focus on these two countries, although many of the problems we identify apply to a varying degree to most other EU countries.

Because of the recent headlines made by the Wirecard case we start with the runner-up, Germany.

Germany

The Wirecard case follows a long tradition of large “household” names such as Siemens, Deutsche bank, Thyssenkrupp, and Volkswagen that have engaged in systemic wrongdoing over extended periods of time and are responsible for most of the fines shown in Table 1.

In one of the largest corruption scandals in history, Siemens was fined $1.6 billion by the Department of Justice in 2008 for systematically paying bribes to government officials around the world, amounting to more than $1.4 billion since the mid-1990s. According to the Securities and Exchange Commission’s investigation, bribery at Siemens was “standard operating procedure” for decades, and the SEC concluded that “the company’s tone at the top […] created a corporate culture in which bribery was tolerated and even rewarded at the highest levels of the company”(SEC, 2008).

In 2015 the Dieselgate scandal unraveled, where it was discovered that several car manufacturers had installed “defeat devices” to cheat emissions tests. Volkswagen had installed the device in 11 million vehicles, some of which emitted up to 40 times more than emissions standards allowed (Gates et al, 2017).

Germany’s largest lender Deutsche Bank has since 2000 paid a whopping $18 billion in fines in the US for alleged infringements ranging from facilitating money laundering and tax evasion, to concealing bribe payments and misleading investors (DoJ, 2021). This is by far the greatest amount paid by any EU bank in the period 2000 – 2020 (Violationtracker.org, 2021)..

Finally, there is the steel conglomerate ThyssenKrupp, which was handed a €479 million fine for bid-rigging by the European Commission in 2007, the highest EU bid-rigging fine ever at the time. The size of the fine was motivated by the fact that, in 2007, Thyssenkrupp was already a repeat offender. In 2019, Thyssenkrupp and three other steel manufacturers were fined $719 million for price-rigging between 2002 to 2016. The firm has also been accused of bribe payments on several occasions (see Nyreröd and Spagnolo 2021a for details).

In reviewing local factors that have enabled these incidents, we find that Germany appears to have a particularly lenient stance toward corporate wrongdoing and a notably hard one against whistleblowers disclosing it. With respect to corruption, for example, bribe payments could be deducted from tax in Germany up until 1999 if paid to foreign officials, and up until 2002 if paid to recipients in the business world (Berghoff, 2017). In October of 2003, the United Nations adopted the Convention Against Corruption. On average, European countries had ratified this treaty halfway through 2007, but Germany was one of the last to ratify the treaty, it did it only in 2014 (UNODC, 2020).

Perhaps more importantly, Germany’s institutional environment seems focused on punishing and deterring whistleblowers, rather than listening to their reports in order to fight corporate wrongdoing. This is likely a crucial enabler of the prolonged wrongdoing we discuss in more depth in Nyreröd and Spagnolo (2021a). It is well known that whistleblowers are essential to detecting corporate wrongdoing (ACFE, 2020). Yet, Germany has some of the worst whistleblower protection laws in the EU (Transparency International 2013, Wolfe et al 2014), and one of the worst records in Europe in terms of mistreating the (obviously few) whistleblowers that dared to denounce corporate wrongdoing (Worth 2020a).

The German opposition to the protection of(truth-telling) whistleblowers from employers’ retaliation was on full display when a public consultation was held on the new EU Directive on whistleblower protection (2019/1937). German industry representatives were particularly active in arguing against it, suggesting that whistleblower protection is not necessary and that the new regulations are a clear signal of mistrust towards companies (BDI, 2019). The German parliament discussed improving the poor whistleblower protections in 2013 but did not enact any improvement of whistleblower protection laws. There are several instances of retaliation against truth-telling whistleblowers where they had very little legal recourse (Worth 2020a; Nyreröd and Spagnolo, 2021a).

The hostile regulatory and political environment to whistleblowers is likely a main factor that has enabled so many German corporations to engage in such prolonged wrongdoing with no records of employees reporting it.

The United Kingdom

We now turn to the winner of our contest, the UK. Over $26 billion of the total fines paid by UK firms in Table 1 is accounted for by the British Petroleum’s (BP) Deep Horizon oil spill in 2010 in the Mexican Gulf. It is estimated that 5 million barrels of oil were released into the ocean, a spill regarded as one of the largest environmental disasters in history.

Internal investigations at BP during the decade preceding this spill had warned senior BP managers that the company repeatedly disregarded safety and environmental rules and risked a serious accident if it did not change its ways. A 2004 inquiry found a pattern of intimidating workers who raised safety or environmental concerns (Lustgarten and Knutson, 2010). The company allegedly flouted safety standards by neglecting aging equipment, delayed inspections to cut production costs, and falsified inspection records. Even before the 2010 spill, officials at the US Environmental Protection Agency had considered debarring BP from receiving government contracts (Lustgarten, 2012). Since 2000, BP has been fined 158 times for environment-related offenses in the US, and again over 60 times since the oil spill in 2010.

Then there is the UK banking sector, with many large banks continuously engaging in wrongdoing, and seemingly more so than elsewhere. CASS (2020: 6) shows how, since 2011, the conduct costs of UK banks have far exceeded that of banks based in the US and Euro area when compared to GDP. In 2017, conduct costs for UK banks represented 0.88% of the UK’s annual GDP, while conduct costs for US and Euro area banks represented around 0.10% or less. In 2018, the conduct costs for UK banks shrank and constituted around 0.55% of the UK’s annual GDP.

In 2010, it was discovered that HSBC had systematically laundered money for some of the bloodiest drug cartels in history through its Mexican subsidiary. Despite numerous internal warnings, complaints from regulators, and internal flags, HSBC Mexico continued laundering money for organizations like the Sinaloa cartel, who not only flood the US with illegal drugs but is considered responsible for the gruesome killings of tens of thousands of people, often innocent civilian casualties at home. The UK’s then-chief financial minister, George Osborne, pleaded with the US Treasury Secretary and others that they do not impose criminal sanctions on HSBC (US Congress 2016).

Another major scandal involving UK banks that have cost regular people billions of pounds was the misselling of “payment protection insurance”. This aggressively marketed insurance had profitability of approximately 90% (Laris, 2020). Several barriers were created to inhibit people from claiming the insurance, such as contract exclusions or administrative barriers, and many people who bought these insurances either did not need them or were unsuitable. As of January 2011, UK banks and financial institutions had paid out £37.5 billion in compensation to customers who were wrongly sold the insurance (Coppola, 2019).

One of the main drivers of corporate wrongdoing in the UK appears to have been the lack of effective corporate sanctions. The “identification principle” requires the identification of a directing mind and will of the company (typically a director), and then proving criminal liability through this person’s conduct and state of mind. This principle has been singled out by several experts as making it “impossibly difficulty” for prosecutors to find companies guilty of serious crimes, especially crimes in large companies with devolved business structures (The Law Commission, 2015: 15). Several UK institutions, such as the UK’s Serious Fraud Office and the Crown Prosecution Service, have also pointed to the identification principle as a central hurdle to their ability to bring corporate prosecutions (Corruption Watch, 2019).

Moreover, effective business lobbying and close connection between politicians, regulators and the financial sector have been prevalent in the UK for a long time and may have exacerbated the already accommodating regulatory environment. Several well-known high-level politicians that affected financial regulation and its implementation for years ended up being hired with handsome pay by financial institutions afterwards (see Nyreröd and Spagnolo 2021a for details).

Regarding regulators, Miller & Dinan (2009: 29) notes that of the 36 people that served on the board of the Financial Services Authority (FSA) between 2000 and 2009, 26 of the members had connections at board or senior level with the banking and finance industry either before or after their term of office, whilst nine continued to hold appointments in financial corporations while they were at the FSA”.

The UK also has an outdated and ineffective whistleblower protection law, the “public interest disclosure act” of 1988 (see e.g., Lewis 2008, Thomas Reuter Foundation and Blueprint for Free Speech 2016, All Parliamentary Committee 2020). At the same time, important UK regulatory agencies have been proactive in neglecting the mounting independent academic research highlighting the effectiveness of the US whistleblowers rewards programs (see Nyreröd and Spagnolo 2021b).

Conclusion

Corporate wrongdoing appears widespread in Europe, and recent cases have been prolonged, severe, and sometimes industry-wide.

The UK and Germany stand out, but other EU countries are no angels. In the case of Germany, an acute aversion to whistleblowers by government institutions appears as a central driver that has enabled corporate wrongdoing. With respect to the UK, ineffective corporate sanctions laws, regulatory/political capture, and a lack of whistleblowers, appear to have driven or enabled firms to engage in prolonged corporate wrongdoing. Similar enablers and drivers are likely present in other EU countries to varying degrees.

There is now an EU Directive on whistleblowing, requiring all member states to put in place retaliation protections for those reporting on corporate wrongdoing. But protections have proven insufficient in a variety of ways and are unlikely to be a game-changer in terms of combating corporate wrongdoing (see e.g., GAP and IBA, 2021).

In the light of the strong independent evidence on the effectiveness of whistleblower reward programs at increasing detection and deterring wrongdoing (see, e.g., Nyreröd and Spagnolo 2021b for a survey), EU Member States seriously concerned about corporate wrongdoing should consider introducing them in a wide variety of regulatory areas.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

The Long Shadow of Transition: The State of Democracy in Eastern Europe

Posted on November 25, 2019 | Policy Brief

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In many parts of Eastern Europe, the transition towards stronger political institutions and democratic deepening has been slow and uneven. Weak political checks and balances, corruption and authoritarianism have threatened democracy, economic and social development and adversely impacted peace and stability in Europe at large. This policy brief summarizes the insights from Development Day 2019, a full-day conference organized by SITE at the Stockholm School of Economics on November 12th. The presentations were centred around the current political and business climate in the Eastern European region, throwing light on new developments in the past few years, strides towards and away from democracy, and the challenges as well as possible policy solutions emanating from those.

The State of Democracy in the Region

From a regional perspective, Eastern Europe has seen mixed democratic success over the years with hybrid systems that combine some elements of democracy and autocracy. Based on the V-Dem liberal democracy index, ten transition countries that have joined the EU saw rapid early progress after transition. In comparison, the democratic development in twelve nations of the FSU still outside of the EU has been largely stagnant.

In recent years, however, democracy in some of those EU countries, such as Bulgaria, the Czech Republic, Hungary, Poland and Romania have been in decline. Poland, one of the region’s top performers in terms of GDP growth and life expectancy, has experienced a sharp decline in democracy since 2015. Backlashes have often occurred after elections in which corruption and economic mismanagement have led to the downfall of incumbent governments and a general distrust of the political system. Together with low voter turnout, this created fertile ground for more autocratic forces to gain power helped by demand for strong leadership.

An example from Ukraine illustrated the role of media, both traditional and social, for policy-making. In some countries of the region, traditional media is strictly state-controlled with obvious concerns for democracy. This is less the case in Ukraine, where also social media plays an important role in forming political opinions. The concern is that, as elsewhere, opinions that gain traction on social media may not be impartial or well informed, affecting public perception about policy-making. A recent case showing the popular reaction to an attack on the former governor of the Central Bank suggests that those implementing important reforms may not get due credit when biased and partial information dominates the political discourse on social media.

Another case is the South Caucasian region: Armenia, Georgia and Azerbaijan. The political situation there has been characterized as a “government by day, government by night” dichotomy, implying that the real political power largely lies outside the official political institutions. In Georgia, the situation can be described as a competition between autocracy and democracy, with a feudalistic system in which powerful groups replace one another across time. As a result, trust in political institutions is low, as well as citizens’ political participation.

In the case of Azerbaijan, there is an elected presidency, but in reality, power has been passed on hereditarily, becoming a de facto patrimonial system. Lastly, in Armenia, the new government possesses democratic credentials, but the tensions with neighbouring Azerbaijan and Turkey have given increasing power to the military and important economic powers. Overall, democratisation in these countries has been hindered by a trend for powerful politicians to form parties around themselves and to retain power after the end of their mandates. Also, the historical focus on nation-building in these countries has led to a marked exclusion of minorities and a conflict of national identities.

The last country case in this part of the conference focused on the current political situation in Russia and on the likely outcomes after 2024. The social framework in Russia appears constellated by fears – a fear of a world war, of regime tightening and mass repressions, and of lawlessness – all of them on the rise. Similarly, the economy is suffering, in particular from low business activity, somewhat offset by a boost in social payments. Nonetheless, it was argued that it is not economic concerns, but rather political frustration, that has recently led citizens to take to the street. Despite this, survey data shows that trust in Putin is still over 60%, and that most people would vote for him again. However, survey data also points out that the most likely determinant of this trust is the lack of another reference figure, and that citizens are not averse to the idea of political change in itself. Lastly, Putin will most likely retain some political power after 2024, transiting “from father to grandfather of the nation”.

Voices from the civil society in the region also emphasized the importance of a free media and an active civil society to prevent the backsliding of democracy. With examples from Georgia and Ukraine, it was argued that maintaining the independence of the judiciary, as well as the public prosecutor’s office, can go a long way in building credibility both among citizens and the international community. The European Union can leverage the high trust and hopeful attitudes it benefits from in the region to push crucial reforms more strongly. For example, more than 70% of Georgians would vote for joining the EU if a referendum was held on the topic and the European Union is widely regarded as Georgia’s most important foreign supporter.

Weak Institutions and Business Development

The quality of political and legal institutions strongly affects the business environment, in particular with regards to the protection of property rights, rule of law, regulation and corruption. Research from the European Bank for Reconstruction and Development (EBRD) highlights that the governance gap between Eastern Europe and Central Asia and most advanced economies is still large, even though progress in this area has actually been faster than for other emerging economies since the mid-‘90s. This is measured through enterprise surveys as well as individual surveys. In Albania, for instance, a perception of lower corruption was linked to a decrease in the intention to emigrate equivalent to earning 400$ more per month. Another point concerned the complexity of measuring the business environment and the benefits of firm-level surveys asking firms directly about their own actual experience of regular enforcement. For example, in countries such as Poland, Latvia and Romania the actual experience of business regulation measured via the EBRD’s Business Environment Enterprise Performance Survey, is far worse than one would expect from the World Bank’s well known Doing Business rating.

From the perspective of Swedish firms, trade between Sweden and the region has remained rather flat in the past years, as the complexity and risks of these markets especially discourage SMEs. Business Sweden explained that Swedish firms considering an expansion in these markets are concerned with issues of exchange rate stability, and the institutional-driven presence of unfair competition and of excessive bureaucracy. Moreover, inadequate infrastructure and the presence of bribery and corruption make everyday business operations risky and costly. It was generally emphasized that countries have to create a safe investment environment by reducing corruption, establishing a clear and well enacted regulatory environment, having dependable courts and strengthening domestic resource mobilization. Swedish aid can play a part, but there is a need to develop new ways of delivering aid to make it more effective.

An interesting example is Belarus, that has seen more economic and political stability than most neighbours, but at the same time a lack of both economic and political reforms towards market economy and democracy. Gradually the preference towards private ownership, as opposed to public, has increased in recent years and the country has seen a rising share of the private sector, even without specific privatization reforms. Nonetheless, international businesses are still reluctant to invest due to high taxes, a lack of access to finance as well as to a qualified workforce, but most importantly due to the weak legal system. An exception has been China, and Belarus has looked at the One Belt One Road Initiative as a promising bridge to the EU. Scandals connected with the two main Chinese-invested projects have damped the enthusiasm recently, though.

The economic and political risks of extensively relying on badly diversified energy sources, as is the case with natural gas imports from Russia in many transition states were also discussed. It was shown how some countries such as Ukraine, Poland and Lithuania have improved their energy security by either benefitting from reverse-flow technology and the EU’s bargaining power or building their own LNG terminals to diversify supply sources. However, either of these, as well as other energy security improving solutions are likely to come with an economic cost, though, that not all countries in the region can afford.

A Government Perspective

The main focus of this section was the Swedish government’s new inspiring foreign policy initiative, “Drive for Democracy”. Drawing from a definition of democracy by Kerstin Hesselgren, an early Swedish female parliamentarian, democracy enables countries to realize and utilize the forces of the individual and draw them into a life-giving, value-creating society. It was emphasized that the values of democracy are objectives by themselves (e.g. freedom of expression, respect for human rights) but also that democracy has important positive effects in other areas of human welfare. The Swedish government views democracy as the best foundation for a sustainable society, equality of opportunity and absence of gender or racial bias.

The “Drive for Democracy” specifically identifies Eastern Europe as one of the main frontiers between democracy and autocracy, and the Swedish government promotes human rights and stability through various bilateral programmes through the Swedish International Development Cooperation Agency, Sida, and multilateral initiatives within the EU, such as the Eastern Partnership. It was also emphasized that democracy is a continuous process that can always be improved, as indeed experienced by Sweden. Political rights were granted to women only in 1919 followed by convicts and prisoners in 1933 and to the Roma people only in 1950. Political and democratic rights are thus never once and for all given, and it is crucial that the dividends from democracy are carried forward to the younger generation.

Conclusion

In sum, the day illustrated clearly how democracy engages all segments of society, from the business sector to civil society, and the potential for but also challenges involved for democratic deepening in Eastern Europe. To get more information about the presentations during the day, please visit our website.

Participants at the Conference

  • PER OLSSON FRIDH, State Secretary, Ministry for Foreign Affairs.
  • ALEXANDER PLEKHANOV, Director for Transition Impact and Global Economics at EBRD.
  • TORBJÖRN BECKER, Director, SITE.
  • CHLOÉ LE COQ, Associate Professor, SITE and Professor of Economics, University of Paris II Panthéon-Assas.
  • THOMAS DE WAAL, Senior Fellow at Carnegie Endowment for International Peace.
  • NATALIIA SHAPOVAL, Vice President for Policy Research at Kyiv School of Economics.
  • ILONA SOLOGUB, Scientific Editor at VoxUkraine and Director for Policy Research at Kyiv School of Economics.
  • KETEVAN VASHAKIDZE, President at Europe Foundation, Georgia.
  • MARIA BISTER, Senior Policy Specialist, Sida.
  • HENRIK NORBERG, Deputy Director, Ministry for Foreign Affairs.
  • YLVA BERG, CEO and President, Business Sweden.
  • LARS ANELL, Ambassador and formerly Volvo’s Senior Vice President.
  • ERIK BERGLÖF, Professor in Practice and Director of the Institute of Global Affairs, London School of Economics and Political Science.
  • KATERYNA BORNUKOVA, Academic Director, BEROC, Minsk.
  • ANDREI KOLESNIKOV, Senior Fellow, Carnegie Moscow Center.

Institutions and Comparative Advantage in Services Trade

Posted on June 3, 2019 | Policy Brief

High office buildings facing sky representing Institutions and Services Trade

Recent studies have highlighted the role of human capital and good economic institutions in establishing a comparative advantage in trade in complex institutions-intensive goods. We show that the effect of institutions on comparative advantage in services trade is quite different: in fact, countries with bad institutions rely significantly more on services exports. More specifically, as the quality of institutions deteriorates, information technology sector (ICT) services exports as a share of total ICT exports increase significantly and countries with worse institutions get a substantial comparative advantage in the provision of ICT services. This is especially applicable to transitional economies characterized by high, arguably exogenous, human capital at the level of most advanced countries.

Introduction

Recent research in international trade has demonstrated that institutions influence the determination of comparative advantage in the trade of goods. Countries with strong domestic institutions have a significant comparative advantage in producing complex, institutions-intensive goods while countries with weak institutions tend to specialize in less complex goods. Through this channel, weak institutions can hinder growth and development (Nunn and Trefler, 2014).

We argue that the role of institutions in services trade can differ significantly from the one in trade in goods. The intuition behind it is that services provision often relies less on institution-driven factors, such as public infrastructure, availability of large number of inputs, property rights and capital investments than the production of complex goods.

We show, in the case of the information technology sector (ICT), that countries with bad institutions rely significantly more on services exports even after controlling for human capital input requirements and availability. We focus on the ICT sector to isolate the differences in the role of institutions in determining comparative advantage in goods and services. Both ICT goods and services provision are equally intensive in human capital and thus present a good opportunity to study differences between goods and services provision.

Our study is motivated by high ICT services exports (e.g. software development) and low ICT goods exports (e.g. computers, phones, etc.) of transition countries which are known to have high human capital and low institutional indicators.

Institutions and ICT Services Exports

Figure illustrates the high human capital availability of transitions economies and weak domestic institutions relative to other countries. Specifically, we categorize countries into four groups: 23 most developed economies (e.g. USA, Canada, Japan and Western European economies); new members of the European Union (a group of 13 countries including Poland, Slovakia, and Baltic countries); transition economies group consists of 17 mostly post-Soviet countries including Russia, Ukraine, Belarus; the most numerous fourth group includes more than hundred other developing countries.

Figure 1. Institutions quality and schooling by country groups

1a

Source: Authors’ calculations, schooling data from Barro and Lee (2013)

1b

Source: Authors’ calculations, institutional indicators data from the World Bank World Governance Indicators

Figure 1a presents an average number of years of schooling, our measure of human capital, for each country group in 2000 and 2010 (the years are chosen based on data availability). The human capital is at a similar level in the most developed economies, EU-13 and transition economies, but significantly lower in other developing countries. Figure 1b illustrates the average institutional quality for each group in 2000 and 2010. Institutional quality for each country is calculated as an average of six indicators, distributed approximately from -2.5 to 2.5: control of corruption, government effectiveness, political stability, rule of law, regulatory quality, voice and accountability, with a lower value corresponding to worse institutional quality. In contrast to education, the average institutional quality of transition economies, although improving from 2000, remains on average lower than the institutional quality of other developing countries.

Consistent with the literature on institutions and comparative advantage in relationship and investment-intensive goods production, ICT goods export from transition economies is significantly lower than in other countries. In contrast, ICT services exports is at a higher level and faster growth in transition economies than in other countries.

Belarus presents a good motivating example. On the one hand, fundamental education in Belarus is at a level of the most advanced countries, which allows 21 universities in the country to educate about 7,000 graduates in IT industry in a year. On the other hand, ICT services exports in Belarus is thriving: over the last 10 years, the growth of ICT services is an eightfold increase (it was 150M USD in 2008 and 1.2B USD in 2017). Nowadays, Belarus is one of the world leaders in ICT services exports per capita. At the same time, ICT goods export is not growing even close to the level of ICT services exports. Over the same time period, it has grown only by about 30 percent: in 2008 ICT goods export was 105M USD, in 2016 – 140M USD (BELARUS.BY, 2019).

The importance of ICT services exports in transition economies is seen in Figure 2. The figure presents ICT services exports as a share of total exports of ICT goods and services. To obtain values for each country group, we average ICT services shares across countries within each group.

Figure 2. ICT services exports as share of total ICT exports

Source: Authors’ calculations, ICT services export data from Trademap, ICT goods export data from WDI

As Figure 2 shows, the average share of ICT services exports in transition economies is higher than the share of ICT services exports in all other groups of countries. Transition economies, characterized by high human capital and weak institutional quality, specialize in exports of services over goods in their ICT exports. This descriptive evidence suggests that abundant human capital, inherited from the USSR and arguably exogenous, shifts to services within the human capital intensive ICT sector when facing weak institutions.

Empirical panel analysis confirms the descriptive evidence. To test our hypothesis, we use the share of ICT services in total ICT exports as a dependent variable and we show that quality of institutions is a significant determinant. Our regressions show that the higher the quality of institutions is, the lower will the share of ICT services in total ICT exports be. Moreover, regression analysis allows us to quantify this dependence: as the quality of institutions increases by 1, which is approximately the difference between Belarus and Georgia (as can be seen in figure 3 below), the share of ICT goods in total ICT services increases by about 20%.

Institutions as a source of comparative advantage in services

To explore the role of institutions in the relative services provision within a sector further, we look at comparative advantage in exporting ICT services. We incorporate a measure similar to Relative Share measure used in Levchenko (2007) for the analysis of comparative advantage in goods export. The measure effectively compares the share of ICT services export for a given country with the world average. The index of revealed comparative advantage in ICT services over ICT goods is computed for country in the following way:

where  is share of ICT services exports in total ICT exports for country,  is the export of ICT services for all countries, and  is the total ICT export (goods plus services) for all countries.

We look at the revealed comparative advantage index across our group of transition economies in figure 3 and see that even within this group, there is a negative correlation between institutions quality and revealed comparative advantage in ICT services.

Figure 3. Revealed Comparative Advantage and Institutions Quality

Source: Authors’ calculations

Countries with high institutional quality, like Georgia, export relatively more goods compared to services. Countries with low institutional quality, like Ukraine and Belarus, have a comparative advantage in ICT services exports.

We hypothesize that the main mechanism responsible for this is as follows. Poor institutional quality, resulting in, for example, corruption and the impossibility to create binding contracts does not allow the countries to produce complex goods in the ICT industry, while the presence of high human capital in these countries allows them to produce ICT services that much less depend on corruption and contracting inefficiencies but are as intensive in human capital as ICT goods.

For a better understanding of the relationship between institutions and comparative advantage determination, we run panel regressions analysing the probability of having a comparative advantage in ICT services in exports of ICT goods and services as a function of institutional quality. Following Balassa (1965), a country has a comparative advantage in ICT services if the share of services in overall ICT exports is higher than the world average, in other words, revealed comparative advantage index is greater than 1. We find that one unit increase in institutional quality reduces the probability of having a comparative advantage in services by about 25%, which means that a country with institutional quality similar to Georgia is about 25% less likely to have comparative advantage than a country with institutional quality similar to Belarus.

Conclusion

In this brief we have discussed the role of institutions in determining comparative advantage in services. Our study argues that, given high human capital, low quality institutions create comparative advantage in services provision. Since low quality institutions act as an implicit tax on the production of complex goods, rational agents reallocate most resources to the production of services that are less sensitive to the institutional quality, while still requiring high level of human capital. We showed that transition economies are characterized by low institutions quality and high human capital. At the same time, transition economies have the highest share of ICT services export in total ICT export. We also showed that institutions negatively affect comparative advantage in ICT services export. Our results suggest that services exports can be a novel development channel for countries with weak institutional, capital investments and infrastructure. Specialization in high-value added services exports provides opportunity for fostering high human capital.

References

  • Arshavskiy, Victor, Arevik Gnutzmann-Mkrtchyan and Aleh Mazol, 2019. “Institutions and Comparative Advantage in Service Trade”, Working paper
  • Balassa, B. (1965). Trade liberalisation and “revealed” comparative advantage 1. The Manchester School of Economics and Social Studies, 33(2), 99-123.
  • Barro, Robert J. and Jong Wha Lee, 2013. “A new data set of educational attainment in the world, 1950–2010”, Journal of Development Economics, vol. 104, pp 184-198
  • Levchenko, Andrei A., 2007. “Institutional Quality and International Trade”, Review of Economic Studies, vol. 74, pp 791-819.
  • Nunn, Nathan and Daniel Trefler, 2014. “Domestic Institutions as a Source of Comparative Advantage”, Handbook of International Economics, Volume 4, Chapter 5, pp 263-315.
  • BELARUS.BY, 2019. “ИТ в Беларуси”, it-belarus, accessed on May 19, 2019

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Ethnic Networks in Ex-USSR

Posted on November 6, 2017 | Policy Brief

20171106 Ethnic Networks in Ex-USSR Image 01

Do ethnic networks facilitate international trade when formal institutions are weak? Using data collected by ethnologists on the share of ethnic groups across countries, this study assesses the effect of ethnic networks on bilateral trade across the sphere of the former Soviet Union. This region provides a perfect setting to test for this effect as both forced re-settlement of entire ethnic groups during the Stalin era and artificially drawn borders in Central Asia led to an exogenous ethnic composition within countries. While ethnic networks do not seem to have played a role in inter-republic trade during the Soviet Union, they did facilitate trade in the years following the collapse of the Soviet Union, a transitional period when formal institutions were weak. This effect, however, eroded steadily from the early 2000s.

Economists and historians alike study the role of ethnic networks in international trade. Some prominent examples are the Greek commercial diaspora of the Black Sea in the 19th century (Loannides and Minoglou, 2005), the Maghribi traders in 11th-century North Africa (Greif, 1993), or the overseas Chinese all around the world in the last decades (Rauch and Trindade, 2002). Such networks facilitate trade by building trust relationships, enforcing contractual agreements in weak legal environments, matching buyers with faraway sellers that speak different languages, and by exchanging information on arbitrage opportunities.

In “Ethnic Minorities and Trade: The Soviet Union as a Natural Experiment”, forthcoming in The World Economy, we study the Soviet Union (USSR) to assess the role of ethnic networks in international trade. We argue that ex-USSR countries are particularly well suited for such a study. Indeed, the ethnic diversity of ex-USSR countries is exogenous, partly due to the creation of artificial borders cutting through ethnic homelands, and partly due to forced relocations (deportations) during the Stalin era, which brought ethnic groups to various remote regions of the USSR. This exogeneity adds power to our empirical strategy.

Ethnic Networks in the USSR

We first build a measure of ethnic networks based on the size of common ethnic groups using ethnologists’ data from the Ethnic Power Relations Dataset on the resulting ethnic groups across ex-USSR countries (Vogt et al., 2015; Bormann et al., Forthcoming). It covers all ethnic groups in every country of the world from 1946 to 2013. While there is some yearly variation in the data, we focus on the cross-section average for the pre-1991 period as per our identification strategy based on exogenous distributions.

Figure 1 gives an overview of the spatial distribution of ethnic groups, such as Russian, Kazakh, or Uzbek.

Figure 1. Ethnic Groups in the USSR

Source: Authors’ own ArcGIS mapping based on the EPR-ED dataset.

Russians are ubiquitous across the Soviet sphere. Countries with the largest ethnic Russian populations are Kazakhstan, Estonia, Latvia and Moldova. At the same time, Russia is very diverse. Almost all of the 60 ex-USSR ethnic groups are present in Russia, and ethnic Russians account for only 62% of the population. Most countries are ethnically diverse. Kazakhstan for example is home to Russians as well as Germans, Tatars, Ukrainians, Uzbeks and Uighurs.

From the information on ethnic populations within each country, we create an ethnic network index as the sum of products of common ethnic groups as a share of the country’s population. Figure 2 presents a matrix overview of the ethnic network index among country pairs with darker shades corresponding to higher scores. Some high scoring country pairs are Russia—Kazakhstan, Ukraine—Russia, Uzbekistan—Tajikistan, Kyrgyzstan—Uzbekistan, Latvia—Kazakhstan, and Ukraine—Kazakhstan.

Figure 2. Ethnic Networks Index

Source: Authors’ estimates. The index is the sum of products of common ethnicities as a share of the country’s population.

Effect of Ethnic Networks on Bilateral Trade in the USSR

Next, we evaluate the impact of ethnic networks on aggregate trade between the countries of the former Soviet sphere. We use trade data from two sources. First, the data on internal trade between Soviet republics from 1987 to 1991 are from the input-output tables of each Soviet Union republic as compiled by the World Bank mission to the Commonwealth of Independent States (Belkindas and Ivanova, 1995). Second, the Post-1991 to 2009 trade data are from the Correlates of War Project (Barbieri et al., 2009, 2016), which offers the best coverage of the trade in the region.

We follow the migrant network and trade literature and estimate a standard log-linear gravity equation controlling for importer-year and exporter-year fixed effects (Anderson and van Wincoop, 2003).

Figure 3 presents the results on the effect of ethnic networks on trade over time. We observe that there is no effect in the period before the end of the USSR, a positive effect after the breakup of the Soviet Union, and an erosion of this effect from 2000s on (omitting Russia from the sample does not alter the results).

These results can be explained with the fact that in the Soviet Union ethnic ties did not matter as official production and trade were centrally planned by the State Planning Committee, Gosplan, and by State Supplies of the USSR, or Gossnab, which was in charge of allocating producer goods to enterprises. Free trade was forbidden. However, once the Soviet system collapsed and before countries could establish more formal trade ties, the first reaction and fallback option for many people was to reach out to their co-ethnics (in the 1990s) to substitute for the broken chains of the centrally planned trade (Gokmen, 2017). The other reason is that the institutional framework was at its weakest in this transitional period, and hence, reliance on informal institutions such as ethnic networks may have been especially strong (Greif, 1993). Once systematic and formal trade ties could be established, more and more traders no longer had to rely on their ethnic networks and this could explain the decline in the effect in the 2000s.

Figure 3. The Effect of Ethnic Networks on Trade over Time

Source: Authors’ estimates. Estimate of the effect of ethnic networks on bilateral trade in a gravity model controlling for distance, contiguity, and importer and exporter fixed effects.

Conclusion

This study shows that ethnic minorities played a role in shaping trade patterns across ex-USSR countries, but only in the early years following the collapse of the Soviet Union. Thus, we argue that reliance on informal institutions, such as ethnic networks, in forming trade relations is especially strong when the institutional framework is at its weakest in the transition period. This message may hold, not only for transition countries, but also for other developing countries with poor institutions.

References

  • Anderson, J. E. and E. van Wincoop, 2003. “Gravity with Gravitas: A Solution to the Border Puzzle,” American Economic Review, 93, 170-192.
  • Barbieri, K., M. G. Omar, and O. Keshk, 2016. “Correlates of War Project Trade Data Set Codebook, Version 4.0.”
  • Barbieri, K., M. G. Omar, O. Keshk, and B. Pollins, 2009. “TRADING DATA: Evaluating our Assumptions and Coding Rules,” Conflict Management and Peace Science, 26, 471-491.
  • Belkindas, M. and O. Ivanova, 1995. “Foreign Trade Statistics in the USSR and Successor States,” Tech. rep., The World Bank, Washington, DC.
  • Bormann, N. C., L. E. Cederman, and M. Vogt, Forthcoming. “Language, Religion, and Ethnic Civil War,” Journal of Conflict Resolution.
  • Gokmen, G., 2017. “Clash of civilizations and the impact of cultural differences on trade,” Journal of Development Economics, 127, 449-458.
  • Gokmen, Gunes; Elena Nickishina; and Pierre-Louis Vezina, forthcoming. “Ethnic Minorities and Trade: The Soviet Union as a Natural Experiment”, The World Economy.
  • Greif, A., 1993. “Contract enforceability and economic institutions in early trade: The Maghribi traders’ coalition”, The American Economic Review, 525-548.
  • Loannides, S.; and I. P. Minoglou, 2005. “Diaspora Entrepreneurship between History and Theory”, London: Palgrave Macmillan UK, 163-189.
  • Rauch, J. E. and V. Trindade, 2002. “Ethnic Chinese networks in international trade”, Review of Economics and Statistics, 84, 116-130.
  • Vogt, M., N. C. Bormann, S. Regger, L. E. Cederman, P. Hunziker, and L. Girardin, 2015. “Integrating Data on Ethnicity, Geography, and Conflict: The Ethnic Power Relations Dataset Family,” Journal of Conflict Resolution, 1327-1342.

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What Does Ukraine’s Orange Revolution Tell Us About the Impact of Political Turnover on Economic Performance?

Posted on November 7, 2016 | Policy Brief

20161107 What Does Ukraines Orange Revolution Image 01

Political turnover is a normal, even desirable, feature of competitive politics, yet turnover in a context of weak institutions can create policy uncertainty, disrupt political connections, and threaten the security of property rights.   What is the impact of political turnover on economic performance in such an environment? We examine the behavior of over 7,000 enterprises before and after Ukraine’s Orange Revolution—a moment of largely unanticipated political turnover in a country with profoundly weak institutions. We find that the productivity of firms in regions that supported Viktor Yushchenko increased after the Orange Revolution, relative to that of firms in regions that supported Viktor Yanukovych. Our results illustrate that the efficiency consequences of turnover can be large when institutions are weak.

Introduction

Politics in much of the world is a winner-take-all contest. When Viktor Yanukovych fled Kyiv in February 2014, for example, he was joined by a close group of associates overwhelmingly drawn from the country’s Russian-speaking East, including Yanukovych’s home region of Donetsk. The governors who ran Ukraine’s regions under Yanukovych fared no better. Oleksandr Turchynov, who served as acting president from February to June of that year, did what all Ukrainian presidents do: he fired the existing governors and replaced them with figures friendly to the new regime.

What is the impact of such political turnover on economic performance? In principle, replacement of political elites can have profound consequences for enterprise owners and managers, who rely on the support of patrons in government for government contracts, direct and indirect subsidies, the security of property rights, and permits to do business. In a system without effective checks and balances, economic policy can also swing widely as power passes from one group to another. Yet little is known about the impact of such changes on firm productivity, a major driver of economic welfare.

We examine the impact of political turnover on productivity and other aspects of firm performance in “The Productivity Consequences of Political Turnover: Firm-Level Evidence from Ukraine’s Orange Revolution” (Earle and Gehlbach, 2015). Our main finding is that the productivity of firms in regions that supported Yushchenko, the eventual winner of the 2004 presidential election, increased after the Orange Revolution, relative to that of firms in regions that supported Yanukovych, the chosen successor of incumbent President Leonid Kuchma. These results demonstrate that political turnover in a context of weak institutions can have major efficiency consequences as measured by differences in firm productivity.

Ukraine in 2004

Three factors make Ukraine in 2004 an appropriate setting for identifying the effect of political turnover on economic performance. First, Ukraine under Kuchma was a paradigmatic case of “patronal presidentialism,” in which the president “wields not only the powers formally invested in the office but also the ability to selectively direct vast sources of material wealth and power outside of formal institutional channels” (Hale 2005, p. 138). Who won the presidential contest had enormous implications for economic activity.

Second, economic and political power was regionally concentrated in Ukraine’s Russian-speaking East—Yanukovych himself was closely affiliated with oligarchs in Donetsk—while the political opposition represented by Yushchenko had its base in the ethnically Ukrainian and less industrialized West. Voting in Ukraine’s 2004 presidential election reflected this regional divide.

Third, few gave Yushchenko much chance of winning the presidency until the presidential campaign was well underway. In the end, it took not only a highly contested election, but also sustained street protests to wrest power from the existing elite.

Together, these considerations imply not only that political turnover in Ukraine could have an impact on firm performance, but also that any such effect could be observed by comparing the performance of enterprises in regions supportive of the two candidates before and after Yushchenko’s unexpected election victory.

The Orange Revolution and Firm Performance

To analyze the impact of political turnover, we use data on over 7,000 manufacturing enterprises that we track over many years, both before and after the Orange Revolution. We compare the evolution of productivity across firms in regions by vote in the 2004 election that was won by Yushchenko, while controlling for any shocks to particular industries in any year, for constant differences across firms in the level or trend of their productivity, and for regional differences in industrial structure. This design avoids many of the other influences on firm-level productivity that might have coincided with the Orange Revolution.

Our primary finding is that the productivity of firms in regions that supported Yushchenko in 2004 increased after Yushchenko took power, relative to the productivity of firms in regions that supported Yanukovych (and, implicitly, his patron Kuchma, whom Yushchenko succeeded as president). This effect is most pronounced among firms that had the most to gain or lose from presidential turnover: firms in sectors that rely on government contracts; private enterprises, given Ukraine’s weak property rights; and large enterprises. Other measures of economic performance suggest that these results are driven by favorable treatment of particular firms, either before or after the Orange Revolution, rather than by broad changes in economic policy.

Conclusion

Political turnover is often desirable. Nonetheless, our results suggest that the distributional consequences can be profound when institutions are weak, that is, when access to those in power is the primary guarantee of market access, contract enforcement, and property-rights protection. Oscillation of privilege from one region or sector to another is inefficient, as firms initiate or postpone restructuring based on who is in power. The optimal solution, of course, is not to restrict turnover, but to make turnover safe for economic activity. This requires that institutions be reformed to guarantee equal treatment for all economic actors—a difficult process that has proceeded with fits and starts in post-Yanukovych Ukraine.

References

Empirical Evidence on Natural Resources and Corruption

Posted on February 25, 2013 | Policy Brief

Empirical Evidence on Natural Resources Image

This policy brief addresses the relationship between resource wealth and a particular institutional outcome – corruption. We overview some recent empirical evidence on this relationship and outline results of an on-going research project addressing a particular aspect of resource-related political corruption: transformation of resource rents into personal wealth hidden at off-shore deposits. The preliminary results from this project suggest that at least 8 percent of oil and gas rents are converted into personal political rents in countries with poor political institutions.