Does the Perception of Governance Institutions Matter for Private Investment_ The Case of Middle East and North Africa.pdf

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BOĞAZİÇİ ÜNİVERSİTESİ 
 
 
 
ISS/EC‐2007‐03 
Does the Perception of Governance Institutions Matter for Private 
Investment: The Case of Middle East and North Africa 
 
Ahmet Faruk Aysan  
Zeynep Ersoy 
M‐A Veganzones‐Varoudakis 
 
 
 
ARAŞTIRMA RAPORU 
RESEARCH PAPERS 
 
 
 
Boğaziçi University Department of Economics Research Papers are of preliminary nature, circulated 
to promote scientific discussion. They are not to be quoted without written permission of the 
author(s). 
 
1
Does the Perception of Governance Institutions Matter for 
Private Investment: The Case of Middle East and North 
Africa? 
 
 
Ahmet Faruk Aysan* 
 
Zeynep Ersoy* 
 
Marie-Ange Véganzonès –Varoudakis** 
 
Abstract 
This paper empirically shows that the perceived quality of governance is an essential determinant 
of the private investment decisions in the developing countries by stressing the existence of different types 
of possible measures of governance. We use three different indicators to measure the perceived quality of 
governance, “Quality of Administration” (QA), “Political Accountability” (PA) and “Political Stability” 
(PS). All of the three indicators were proved to be significantly –although at different levels of significance 
and magnitudes of influence- contributing for private investment decisions. We also confirm that Middle 
East and North Africa (MENA) region could have achieved a better private investment performance if it 
had an enhanced level of perceived institutions. In particular the low level of political accountability has 
been an influential factor which has been holding back the region from reaching its private investment 
potential. 
Keywords: Perceptions, Institutions, Governance, Private Investment, Middle East and North Africa.  
JEL Classification: P4, E2, E6, D02 
 
 
 
Corresponding Author: Ahmet Faruk Aysan   
Boğaziçi University 
Department of Economics 
34342 Bebek, Istanbul, Turkey 
Phone: 90-212-359 76 39 
Fax: 90-212-287 24 53 
ahmet.aysan@boun.edu.tr  
 
 
 
* Boğaziçi University, Department of Economics, Istanbul, Turkey 
** CERDI, CNRS, Université d’Auvergne, France 
 
2
Does the Perception of Governance Institutions Matter for Private Investment: The 
Case of Middle East and North Africa? 
1. Introduction 
The quality of governance in the Middle East and North Africa (MENA) region is 
generally considered to be inadequate. Although this is true for a large number of 
institutions, quality of governance is a wide-ranging phenomenon and its distinct features 
may exhibit quite different paths for the same region (see Table 1).  For example in terms 
of the administrative quality and political stability indicators used in this paper, MENA 
ranks third -with scores of 0.14 and 0.07 respectively- among the six developing regions 
and is superior to Africa (AFR), Latin America (LAC) and South Asia (SAS). This basic 
comparison shows that contrary to common belief, MENA is not particularly deficient in 
institutional quality when measured by these indicators. On the other hand political 
accountability for the MENA is the lowest among the regions with the score of -0.90. The 
disaggregated governance variables in our sample of developing countries, which are 
shown in Table 2, also confirm the same result. The level of the variables associated with 
administrative quality –corruption, law and order, investment profile and bureaucracy 
quality- and political stability –government stability, internal conflict, external conflict 
and ethnic tensions- look rather satisfactory for the MENA region. The region is ranked 
as the second best in the categories of bureaucratic quality and investment profile and 
“the best” in the categories of government stability and ethnic tensions. In contrast, in 
terms of political accountability variables –civil liberties and government stability- 
MENA has the lowest score among all the regions1. 
                      
Table 1 Governance Indicators (average 1970-2002) 
Region 
Administrative 
Quality  
Political 
Stability  
Political 
Accountability  
AFR  
-0.38 
-0.63 
-0.55 
EAP 
0.59 
0.29 
-0.05 
ECA 
0.29 
0.42 
0.03 
LAC 
-0.31 
-0.09 
1.16 
MENA 
0.14 
0.07 
-0.90 
SAS 
-0.55 
-0.88 
0.46 
Sources: International Country Risk Guide, Freedom House, and the Authors’ 
calculations. 
 
The different levels of advancement displayed by the various governance 
indicators in the MENA region (as well as other regions) suggest that the mechanisms 
shaping each indicator can be quite different. Hence these different types of governance 
institutions are also expected to exert their influences on the economic variables 
differently as well. Hence, in studying the relationship between governance and 
economic indicators, unique influence of each category of institution needs to be taken 
into account. In this paper we focus on the various different dimensions of governance 
                                                 
1 Our argument supports the view presented by World Bank (2004). 
 
3
indicators and analyze the impact of various types of perceived governance institutions 
on the level of private investment in MENA. 
    
 There is an emerging literature on the quality of governance which advocates that 
“good” governance institutions are needed for successful market-based economies2. The 
impact of institutions on economic growth3 , GDP per capita4 and or volatility of the 
economic activity5 have been studied extensively in the recent years. Although private 
investment is arguably one of the main channels through which institutions exert their 
influence on growth and economic development, very little research is done on the 
relationship between private investment and governance institutions. The existing studies 
on governance and private investment have generally concentrated on the effect of the 
rule of law6. However, there is not much research done on the other types of governance 
institutions. Moreover empirical link between these variables and private investment is 
not strongly established. This is particularly the case for corruption and bureaucratic 
administration7 as well as the quality of the democratic institutions8. In terms of political 
instability and policy uncertainty there are some studies which have been successful in 
proving the impact of institutions on private investment. 9 
Private investment is very much responsive to the changes in the business 
environment; which governance constitutes an important element. The forward looking 
nature of investment also highlights the importance of a stable and secure environment – 
in particular the security of property rights. High quality governance institutions reduce 
uncertainty and promote efficiency10. Using a large sample of countries, World Bank 
(2004) finds a strong positive link between the investment climate and private investment 
                                                 
2 See in particular Rodrik (1999) and Frankel (2002). 
3 See for example Knack and Keefer (1995), Acemoglu, Johnson, and Robinson (2001), Rodrik, 
Subramanian, and Trebbi (2002)  
4 See Hall and Jones (1999), Acemoglu, Johnson, and Robinson (2001), Easterly and Levine (2003), and 
Rodrik, Subramanian, and Trebbi (2002).  
5 See for example Acemoglu, and Taicharoen (2003). 
6 Under this category the security of the property rights is the most studied and empirically validated 
component. See North (1981), Knack and Keefer (1995), Calderon and Chong (2000), Easterly and Levine 
(2003), Rodrik, Subramanian, and Trebbi (2002), and Saleh (2004).     
7 See Keefer (2002). 
8 Pastor and Sung (1995) is among the few articles that have been able to establish a link between the 
political institutions and private investment. 
9 See Rodrik (1991) and Le (2004) 
10  North (1990) 
Table 2 Disaggregated Governance Variables (average 1970-2002) 
Region Corruption 
Bureaucracy 
Quality 
Investment 
Profile 
Law 
and 
Order 
Political 
Rights 
Civil 
Liberties 
Government 
Stability  
Internal 
Conflict  
External 
Conflict 
Ethnic 
Tensions 
AFR  
2.81 
1.49 
5.42 
2.71 
-5.10 
-4.97 
6.07 
6.96 
8.44 
2.99 
EAP 
3.22 
2.37 
6.29 
3.89 
-4.29 
-4.49 
7.07 
9.28 
9.99 
3.33 
ECA 
3.43 
1.71 
5.69 
4.04 
-4.20 
-4.39 
6.94 
9.68 
10.06 
3.92 
LAC 
2.71 
1.44 
5.73 
2.81 
-2.72 
-3.02 
6.13 
7.61 
9.75 
4.34 
MENA 
2.98 
1.95 
5.89 
3.39 
-5.41 
-5.51 
7.62 
8.30 
8.34 
4.34 
SAS 
1.98 
1.81 
5.38 
2.33 
-3.38 
-4.08 
5.73 
6.60 
8.27 
2.29 
Sources: International Country Risk Guide, Freedom House the Authors’ calculations. 
 
4
decisions11. In that study the reason for this observed relationship is suggested to be the 
fact that better governance improves the investment climate by improving bureaucratic 
performances and predictability which in turn reduced uncertainty and the cost of doing 
business.   
Since governance is an important determinant for investment, private investors 
would want to know about the quality of the governance institutions at the time of 
making investment decisions and also in the future when they will be getting their 
returns. Although good institutions are beneficial for reducing uncertainty, the 
perceptions about the quality of the governance institutions may themselves be a source 
of uncertainty, because investors may not know the actual governance establishments 
with 100% accuracy. Uncertainty associated with private investment arises both from the 
unknown future factors and imperfect information about the current state of governance 
variables. Investors collect information about the quality of governance institutions from 
consulting firms as well as from the other sources to form their perceptions about these 
institutions. Since their opinions on governance institutions are crucial in making the 
investment decisions, perceived level of quality of the governance institutions needs to be 
analyzed as a determinant of private investment. This paper incorporates this argument 
into its estimation process. 
For the governance variables we use the data obtained from International Country 
Risk Guide and Freedom House. These are independent private firms that provide 
consulting services to international investors. We argue that, this data set can be a good 
proxy to measure the perceptions of the investors about the institutions. At this point it is 
important to point out the existence of the possible distinction between the perceived and 
actual institutions. Governance institutions are not expected to show abrupt changes from 
one year to another, but in our data set we do observe sudden variations for certain years. 
This may be due to the fact that investors have incomplete-asymmetric information about 
the quality of governance institutions in the economy. At extraordinary times-like crises- 
governmental bodies are forced to reveal the true quality of their institutions. With the 
arrival of the crises government institutions are faced with a real examination and 
information concerning the true quality of the institutions is uncovered. At regular times 
investors may not be able to get healthy information about the quality of the institutions 
to form their perceptions and without additional information they may not be able to 
modify them. This line of argument is one explanation for the observed pattern of the 
governance data. 
 A wide set of governance variables -which are not commonly used as the 
determinants of private investment in the empirical literature- are employed in our study. 
These variables are likely to be highly correlated. To account for the multi-collinearity 
issue we use principal component analysis to aggregate a few broad categories of 
governance institutions. Based on the existing literature, we classify governance 
                                                 
11 The World Bank (2004) has investigated the correlation between private investment and ICRG’s index of 
“investment profile”. This index is based on measures of contract enforceability, expropriation, profit 
repatriation, risk of operations, taxation and payment delays. 
 
5
institutions in three groups as “Administrative Quality”, (QA), “Political Accountability” 
(PA), and “Political Stability” (PS). 
Aysan et.al. (2006a) have reexamined and updated the International Finance 
Corporation (IFC) data set for private investment by consulting the national sources, IMF 
and World Bank series and country economists. We use their disseminated data set 
(which covers the period from 1970 to 2002) in our study. High quality data for the 63 
developing countries are included in their database.  
 We use a simultaneous equations model to stress the joint determination of 
private investment and different forms of governance institutions. The procedure of this 
model is justified by the fact that private investment can have a direct effect on the 
institutions. For instance, an increase in the private investment strengthens the private 
sector’ incentive in lobbying12. Hence these newly-empowered corporate bodies are 
likely to exert more pressure on the government and demand institutional changes for 
their own well-being. Our findings show that the perceived quality of governance 
institutions plays an important role in private investment decisions. “Administrative 
Quality” (QA) and “Political Stability” (PS) and “Political accountability” (PA) are 
crucial for the determination of private investment. This result supports the hypothesis 
that different categories of governance institutions effect private investment through 
different channels. 
The paper is organized as follows. The second section introduces our 
classification of governance institutions. The third section presents the other determinants 
of private investment that will be taken into consideration in our empirical analysis and 
highlights the importance of these factors for the MENA countries. The fourth section 
introduces the model of private investment tested and the results of the estimations. The 
sixth section uses this model to determine which reasons account for the private 
investment performance of the MENA region. It also identifies the incentives to be 
provided to enhance private investment in the future. The last section concludes.   
2. Categorization the Governance Institutions 
To study the impact of different types of governance institutions on the private 
investment, we first distinguish between the various dimensions of governance. The 
existing literature on the classification of institutional quality provided us the guidelines 
for categorization the governance institutions.  
Kaufmann, Kraay and Mastruzzi (2003) categorize these institutions under six 
groups.  Their measures of governance indicators are based on 194 variables drawn from 
17 different sources. “Government Effectiveness” and “Regulatory Quality” summarize 
the ability of the government to devise and implement sensible policies. The respect of 
the citizens and the state for the institutions which govern their interactions is categorized 
as “Rule of Law” and “Control of Corruption”. "Political Stability and Absence of 
Violence" measure perceptions of the likelihood that government in power will not be 
                                                 
12 See Altmann  
 
6
destabilized and indicate the continuity of policies. “Voice and Accountability” captures 
the process by which the citizens of a country are able to participate in the selection of 
governments. The World Bank (2004) constructs 
two indices on “Political 
Accountability” and “Administrative Quality” by aggregating the existing relevant data 
sets for these aspects of governance.  
Taking these categorizations into account, we grouped institutional variables into 
three broad units: “Administrative Quality” (QA), “Political Accountability” (PA) and 
“Political Stability” (PS). 
2.1. Quality of Administration  
Following the World Bank (2004), we have defined the first governance indicator 
as the “Quality of Administration”. This index contains four variables from the 
International Country Risk Guide (ICRG): “Control over Corruption”, “Quality of 
Bureaucracy”, “Investment Profile”, and “Law and Order”. These four variables are 
aggregated using the Principle Components Analysis (PCA) to form a broad index for the 
Quality of Administration13. This governance unit shows the capacity of the government 
to provide investment-friendly and reliable conditions for the private investors. 
The negative effect of corruption on the economic variables is firmly established 
in a number of studies14. Mauro (1995) empirically shows that corruption reduces growth. 
For private investors, corruption increases the initial and operational costs of investment 
in addition to the uncertainties about the timing and application of government policies. 
The “Quality of Bureaucracy” index of ICRG shows the ability of the government to 
generate and implement sound policies. Also, this index indicates that “countries where 
the bureaucracy has the strength and expertise, govern without drastic changes in policy 
or interruptions in government services. “Investment Profile” index measures the 
“government’s attitude to inward investment as determined by the assessment of four 
sub-components: risk to operations, taxation, and profit repatriation and labor costs”. By 
its nature investment requires people to make long-term decisions. Hence risk to 
operations and other uncertainties about future policies are important for investment 
decisions. In the “Law and Order” index, the law element presents an “assessment of the 
strength and impartiality of the legal system”, while the order element is related with the 
“popular observance of the law.” Different aspects of the business environment are 
important for investment, but the security of property rights and the rule of law and their 
effects on private investment are seen to be the most important ones and these are 
empirically validated through a number of studies15. Investors are concerned about the 
future state of the economic-social institutions in order to protect their investments. 
Specifically they need institutions that preserve the right of private property, ensure 
                                                 
13 The variables forming the QA index is likely to be highly correlated. In order to account for the multi-
collinearity problem in using these variables in the same regression equation PCA method is used to 
aggregate these variables. The other governance indicators are also formed by using this method. 
14 World Bank (2005) and Mo (2001). 
15  See North (1981); Knack and Keefer (1995); Calderon and Chong (2000); Easterly and Levine (2003); 
Rodrik, Subramanian, and Trebbi (2002), and Saleh (2004). 
 
7
equitable and consistent rule of law in protecting this right, as well as effective incentives 
to respect and enforce it. 
2.2. Political Accountability  
 Our second governance indicator is “Political Accountability”.  This unit consists 
of two indicators from Freedom House (FH): “Civil Liberties” and “Political Rights”. 
 Since all types of investments involve a certain degree of irreversibility, private 
investment decisions are highly sensitive to the perception of the credibility and 
persistence of the political regime, as well as of policies16. A participatory political 
system provides the stability of social institutions and ensures a broad public support to 
policies, which are in this case more sustainable in the long run. The empirical literature 
on democratic participation has concentrated on the effects of transparency and 
accountability on growth, using data on civil liberties, political rights, and freedom of 
press. These attempts to establish causal links between democracy and growth generated 
moderate success17. 
2.3. Political Stability  
The last indicator is “Political Stability” and is composed of the following 
variables from ICRG: “Government Stability”, “Internal Conflict”, “External Conflict” 
and “Ethnic Tensions”. Political instability creates uncertainty which has detrimental 
effects for the level of investment. Using different measures of political uncertainty, 
various studies have brought empirical evidence that institutions associated with political 
instability hinder investment18. 
All of the three indicators reflect the perceptions of the private investors about the 
quality of the governance institutions. These perceptions are not necessarily the same as 
the actual level of the quality of the institutions. 
3. Other Determinants of Private Investment and Governance Institutions 
In studying the private investment performance of the developing countries some 
additional issues needs to be taken into account. In particular, the business environment 
in these countries is not always competitive and investors face additional limitations 
which are not accounted for in the neo-classical model. The debate about how to 
incorporate these factors into the estimation procedure gave rise to the usage of different 
types of variables as determinants of private investment by various authors19. In this 
                                                 
16 See in particular, Rodrik (1991) and Serven and Solimano (1993). 
17 In the contex of private investment the study of Pastor and Sung (1995) is one of the few articles to find a 
positive influence. 
18See Rodrik (1991), Alesina and Perotti (1996), Le (2004), Brunetti and Weder (1994). In the growth 
context see also Alesina et al. (1996), Svensson (1998), Olson et al. (2000). 
19 See for example Greene and Villanueva (1991) and  Blejer and Khan (1984)  
 
8
paper we address some of the constraints encountered in the developing world, especially 
the ones linked to economic policy and institutional quality. 
In the macroeconomics literature, the neoclassical flexible accelerator model is 
the most widely accepted model of investment. This model is based on the neoclassical 
idea of the theory of the firm (Jorgenson, 1963), which claims that enterprises decide to 
invest so as to generate more profit in the future. The investment function is derived from 
the optimization problem of the firms, which maximize current and expected profits by 
equating the production prices to their marginal costs. The net investment is the gradual 
adjustment of the actual capital stock to its desired level, which is derived from the 
maximization of profit. The determinants of investment in the neoclassical flexible 
accelerator model include the expected aggregate demand (the accelerator), the user cost 
of capital, the wage rate and the initial capital stock.  
One of the main assumptions of this model - competitive markets- , however, 
does not often hold in the developing countries. Empirical validation of the model 
appears to be successful for several developed countries. However the firms in 
developing countries face certain constraints that are not accounted for in the 
conventional neoclassical theory20. Next, we will examine some of these constraints – 
especially the ones that are more relevant for the MENA region- in detail. 
One of the main constraints confronted by the investors in the developing 
countries is the deficit in economic reforms. This is also the case for the MENA countries 
which have lagged behind other regions in terms of reforming their economy (Nabli and 
Véganzonès -Varoudakis, 2006). Structural reforms constitute an important determinant 
of the actual and future profitability of private investment. These reforms are mostly 
directed towards the establishment of a sound financial system and an economy that is 
fully integrated to the world. Hence our structural reforms index includes trade policy and 
financial development. 
Financial development is an important determinant for private investment since it 
creates profitable investment opportunities. A developed financial system mobilizes and 
allocates resources to the projects that will create the most amount of surplus. This 
efficiency in the allocation process is derived from the enhanced technological 
specialization and reduced “information, transaction, and monitoring costs”21 which leads 
to a better selection of projects and a more advanced diversification of risks. This allows 
the firms to finance more investment projects and increases the productivity of new 
investments (see Levine, 1997, for a synthesis). Financial markets are not fully developed 
in the emerging economies. Hence the neoclassical assumption of flexible accelerator 
model about the limitless availability of credit supply by the banking sector cannot be 
taken for granted in these countries. As pointed out by Blejer et.al (1984) and Rama 
(1993) the quantity of the available funds in these countries may be restricted by 
government policies. One of the deriving forces behind these policies can be the public 
                                                 
20 See in particular Shafik (1992), Agenor and Montiel (1999) and Aysan et al. (2006b) for a discussion and 
additional references. 
21 See Creane, Goyal, Mobarek and Sab (2004).  
 
9
deficits and public debt, which can lead to financial repression and to crowding out of 
private investment. On the empirical side, the impact of financial development on private 
investment is now well documented22. In the MENA region, reforms needs to particularly 
focus on the development non-bank financial sector. The corporate bond market and 
equity market are not active and the investors are forced to rely on bank credits23.  
Trade reforms can also encourage private investment decisions.  The link between 
persistent growth and trade openness is generally acknowledged24. Trade openness 
increases competitiveness and provides access to enlarged markets (Balassa, 1978; Feder, 
1982) and can contribute to the productivity gains. In addition, trade openness influences 
the availability of external credit -- considering the general consensus on the role of 
tradable goods in providing positive externalities in the form of collateral for external 
financing (Caballero and Krishnamurthy, 2001). Some countries in the MENA region are 
highly disintegrated to the world trade and this has adverse consequences on foreign 
investment levels in the region.25 
In addition to their direct effects mentioned above, economic reforms are also 
expected to affect private investment through their impact on institutional quality. For 
example, there is some evidence that greater openness to trade and stronger competition 
are conducive to institutional improvement26. Opening up markets may help to weaken 
vested interests and reduce rents derived from prevailing economic and institutional 
arrangements. Trade openness may also lead to demands for institutions more suited to an 
increasingly varied and complex range of transactions (See IMF, 2003). 
Human capital is an important determinant for the level of private investment. It is 
generally viewed as a complementary factor of physical capital. In this study, human 
capital index is composed from health and education variables. Human capital stimulates 
private capital formation by raising the profitability of investment and can provide 
positive externalities27. Since skilled workers are better in dealing with changes, a skilled 
work force is essential for firms to adopt new and more productive technologies28  
Additionally, human capital gives rise to institutions with better quality. More 
educated people with higher life expectancy become more competent bureaucrats and -- 
in addition to better monitoring of the functioning of government officials -- demand for 
better quality of bureaucracy (Galor et al., 2005). Also, educational attainment reduces 
the political instability by encouraging a consensus environment. This idea constitutes the 
one of the classical approaches in the literature to highlight the importance of education 
in bringing better institutions (Lipset, 1959). From the democratic accountability point of 
                                                 
22 In his survey of investment functions in developing countries, Rama (1993) presents the positive effect of 
financial development on private investment in twenty-one of the thirty-one papers surveyed. 
23 See Mc Call (2004) 
24 See Bisat et. al. (1996) and the references there. 
25 See Bisat et.al. (1996) 
26 For the positive spillover from trade openness on institutions see Berg and Krueger (2003), Islam and 
Montenegro (2002) and Wei (2000).  
27 See Lucas (1988) and Mankiw, Romer and Weil (1992). 
28 See in particular Acemoglu and Shimer (1999). 
 
10
view, a more educated society is more likely to be enfranchised in terms of civil rights 
and liberties (Acemoglu and Robinson, 2001). These arguments support the view that in 
addition to its direct effect, human capital can influence private investment decisions 
through its effect on the institutions. 
The improvements in the level of educational attainment experienced by the 
majority of the developing countries have not been sufficient to change the perceptions of 
private investors about the skills of the workers in these countries. This is the case for the 
MENA region, where progress is still needed in order for the region to catch up with the 
developed world as well as with some of the developing regions29. As pointed by the 
World Bank (2004), to meet this challenge, MENA countries have to gear up their 
educational system both to improve basic education and to equip the labor force with 
skills appropriate for the enterprises to invest efficiently.  
In the developing countries, the government is still the pre-dominant actor in the 
economy. Hence the level of government consumption can be an important determinant 
for private investment for these countries. When government spending is used to finance 
projects which increase the profitability of the private investment, then the effect of this 
factor on private investment will be positive. Improvements in the infrastructure system 
and quality of health and education services financed through the government budget can 
be shown as examples of such cases30.  Also an increase in the demand for private sector 
products by the government can stimulate private investment. 
 On the flip side government consumption can reduce the amount of funds 
available to the private sector. This effect is most likely to be observed through the 
increase in the interest rates (Binter 1977) and future tax burden (Friedman 1976). If the 
excess amount of government spending is financed through “printing money” then this 
leads to an increase in the level of the inflation which in turn increases uncertainty. 
Besides using external debt for government deficit may harm the financial and political 
stability, given that the country can encounter difficulties in reimbursing its debt. The 
negative impact of instability and uncertainty on private investment is empirically 
validated in a number of studies31. Since government consumption can have beneficial as 
well as damaging effects on the private investment in theory, the overall impact of this 
variable on the level of private investment needs to be analyzed empirically. 
Government spending is expected to have a positive effect on governance. For 
example the improvements in the living standards of the bureaucrats caused by the 
increase in wages can induce them to form better governance institutions. 32 
4. The Econometric Analysis  
                                                 
29 See Nabli and Véganzonès -Varoudakis (2006). 
30 See for example Bisat et.al. (1996). 
31 References for political uncertainty and instability are given in the introduction section. In addition to 
those, for macroeconomic uncertainty see Serven (1997) and (2002).  
32 See Azariadis and Lahiri (2002) 
 
11
4.1. The Model Tested 
The aim of the model tested is to isolate the effects of the perceived quality of the 
different governance indicators on private investment. In our empirical model, 
endogenous variables are the share of private investment and the various measures of 
governance, namely “Quality of Administration” (QA), “Political Accountability” (PA) 
and “Political Stability” (PS).  The endogenous variables have the ability influence each 
other and hence determined simultaneously. To incorporate this two-way causality into 
our analysis, we form a system of equations to estimate the share of private investment 
(PI) in GDP and quality of governance institutions (IQ) simultaneously.  In the private 
investment equation, perceived quality of governance institutions is expected to increase 
the private investment. In the other equation in which governance is the dependent 
variable, the sign of the coefficient of private investment is expected to be positive. 
This system of equations is estimated using three stage least squares by 
controlling for the other determinants which include variables that affect both of the 
endogenous variables.  Three stage least square (3SLS) estimation allows to use the links 
between endogenous variables efficiently.  Since endogenous variables are correlated 
with the error terms, they have to be instrumented out using exclusion restrictions. 
The model estimated is the following: 
 (A)         
it
i
it
it
X
IQ
PI
1
1
2
1
0
ε
α
α
α
+
+
+
=
 
 (B)        
it
i
it
it
X
PI
IQ
2
2
2
1
0
ε
β
β
γ
+
+
+
=
 
 
 
 
Where: 
− 
it
PI
 is the share of private investment in GDP 
− 
it
IQ  represents the various indexes of governance (QA, PA and PS) 
− 
i
X 1  and 
i
X 2  are the other control variables in private investment (PI) and 
governance (IQ) equations respectively 
− 
it
1
ε
 and 
it
2
ε
 are the error terms of each equations.  i  signifies the country and t  
represents the time of the variable. 
 
As mentioned before, the determinants of investment in the neoclassical flexible 
accelerator model include the expected aggregate demand (the accelerator) and the user 
cost of capital. The private investment equation in our model includes real interest rate 
(Realr) to capture the user cost of capital and the GDP growth rate in last year (Growth) 
to account for the accelerator effect33. These two variables are assumed to have no direct 
effect on the level of the perceived quality of governance. Hence they are not included in 
the governance equations. This detail is crucial for the identification of the system. 
                                                 
33 GDP growth rate enters the equation with an expected positive sign whereas the effect of the real interest 
rate is expected to be negative. 
 
12
GDP per capita, variations in the structural reforms (Struct Ref), human capital 
(Human Cap) Government consumption (GCons) and oil export as a percentage of 
merchandise export (Oil export) enters into both of the equations as explanatory 
variables. GDP per capita is included in the private investment equation to take into 
account the argument put forward by the Solow growth model; Countries with lower 
GDP per capita are expected to gradually catch up with the more developed counterparts 
with their higher capital investment over time. Additionally, GDP can be a proxy for the 
market size for goods and services which can affect the differences in the private 
investment ratios across the countries. GDP per capita variable in the governance 
equation is expected to exert a positive influence because of the theoretical argument that 
more developed countries can afford to have better institutions34. This argument may 
influence the perceptions of the investors when they are forming their investment 
decisions. 
Structural reforms index is composed from trade policy (TP) and financial 
development indicators. Financial development is proxied by the private credit by banks 
and other depository institutions (Pcr).  Trade policy indicator is formed by subtracting 
the exports of oil and mining products and the “natural trade openness” (constructed by 
Sachs and Warner 1997) from the commercial openness (calculated by aggregating the 
export and import in total GDP). The trade policy and financial development variables 
form the structural reform index after applying the principal component analysis.  
Structural reform is expected to enhance the level of private investment and the perceived 
quality of the governance institutions. 
To form the Human capital index life expectancy at birth and average years of 
primary, secondary and higher schooling35 variables are aggregated using the principal 
component analysis. Human capital is widely considered to improve the private 
investment and the quality of the governance institutions. 
The ratio of government consumption to GDP (GCons) is used to account for the 
level of government consumption and this variable is included in both of the equations. 
As mentioned before the effect of this variable on private investment is not certain ex-
ante. On the other hand the expected coefficient of the government consumption variable 
in the governance equations is positive. 
Oil export as a percentage of total merchandise export is also included as 
explanatory variables in both equations. The validity of the natural curse hypothesis is 
tested by incorporating this variable in the investment equation. When a country relies 
more on natural resources extraction in its export, there can be less incentives to invest 
for other products36. Hence the sign of this variable in the private investment equation is 
expected to be negative. The share of oil exports has also implications for the quality of 
governance institutions in the economy. Countries which are less dependent on natural 
resources are expected to form better governance institutions. The natural resource 
                                                 
34 Azariadis and Lahiri (2002) 
35 For the education variables the portion of the  population  that is over 15 years old is considered. 
36 This may stem from the increase in the cost of labor as mentioned by Rodriguez and Sachs (1999). 
 
13
abounded countries do not need to mobilize the society to increase the overall level of 
earnings. The governing body can control the economy by collaborating with a small 
number of people in the society. The outcome from such a production arrangement does 
not maximize the well-being of the society as a whole and hence do not lead to 
governance institutions which are in favor of the society37. In these kinds of 
circumstances, also the elite are not eager to provide high-quality institutions by bearing 
in mind the future effects of today’s enfranchisements (Acemoglu and Robinson, 2001) 
and engage in more rent-seeking activities. From the above discussion, we can draw the 
conclusion that oil export as a percentage of total merchandise export is expected to have 
a negative coefficient in the governance equations. 
The tenure of the system (Tensys) from Keefer et al. (2001) is excluded from the 
investment equation to identify the system.  Tensys reports the number of years that an 
administrative system -regardless of whether autocratic or democratic - lasts in the 
country. Time is required for institutions to settle down. This variable is an important 
determinant for establishment of high-quality institutions. Tenure of system is assumed to 
exert its effect on the private investment only through the governance institutions; hence 
it is not included in the governance equations. Finally, a regional dummy for the Middle 
Eastern and North African countries (MENA) appears as a right hand side variable in 
both of the equations. This variable is essential in understanding the position of MENA 
countries among the other countries and to see whether MENA substantially differs from 
the rest of the world in terms of private investment and of perceived quality of the 
governance performance.   
4.2. Estimation Results 
Equations (A) and (B) have been estimated on an unbalanced panel of 32 
developing countries over 1970-2002 using the three stages least square estimations 
technique (3SLS). Three sets of regressions have been calculated, each one utilizing a 
different governance indicator to account for the perceived quality of the government 
institutions. Tables 3 to 5 present equations when “Quality of Administration”, “Political 
Stability” and “Political Accountability” are respectively taken into consideration.  
4.2.1 Administrative Quality 
From table 3- column 1; where Administration Quality (QA) is used as a measure 
of governance; we can conclude that the QA has a positive and significant coefficient at 
the 5 percent level in the investment equation. This result supports the view that the 
perception of a low level of corruption, a good quality of bureaucracy, a reliable judiciary 
system, a clear security of property rights, a reasonable risk to operations, as well as a 
sound taxation and regulation are primarily important for the private investment 
decisions.  
Our findings are robust to the introduction of other explanatory variables. In this 
specification especially the structural reforms have a significant impact on private 
                                                 
37 Ross (2001) and Bellin (2001). 
 
14
investment. Hence, our estimations emphasize that, although the perceived quality of 
governance is a major determinant of the private sector decisions, the role of economic 
policies cannot be ignored. This result confirms that firms in developing countries face 
constraints that are not accounted for in more developed economies and shortcomings in 
the trade policy and financial development have a long term impact on growth 
performances, through private investment decisions.  
 The accelerator variable has the expected positive sign and it is significant. This 
implies that anticipation of an increase in the overall level of demand stimulate the 
investment decisions. Although not significant, interest rate appears to exert a negative 
effect on the private investment, which is consistent with the user cost of capital theory. 
Our model fails to verify the Solow hypothesis of decreasing return to scale of physical 
capital accumulation.  The coefficient of the GDP per capita variable is not significant. 
The influence of the human capital variable is not significant either. Government 
consumption variable has a significantly negative coefficient in equation 1 (Table 3). 
This finding indicates that, for the countries that are included in our sample the crowding 
out effect of government spending outweighs the crowding in effect. 
 The coefficient of the oil export variable as a percentage of total merchandise 
export is significant and negative in equation 1. This result confirms the natural curse 
hypothesis. Similarly, the regional dummy for MENA countries has a negative 
coefficient. MENA countries seem to be diverging from the rest of the world in terms of 
private investment. However, this dummy variable is not significant .This result is most 
likely stem from the inclusion of the oil exports variable in the regressions.  
On the “Administrative Quality” equation (Table 3, equation 2), our results 
uncover the positive influence of several factors on the perceived quality of the 
administration. For example GDP per capita-although small- has a significantly positive 
coefficient which implies that countries with superior resources are able to develop better 
institutions and/or investors perceive the high level of GDP as an indicator of good 
institutions. Besides, private investment helps improving the administrative quality 
considerably. This last result validates the usage of the 3SLSQ estimation technique in 
order to account for the two way causality issue. Tenure of system is also an important 
determinant for the administrative quality. 
Government spending has a significantly positive coefficient for 
the 
administration quality. Our estimations fail to confirm the negative impact of the share of 
oil export in merchandise export. This result is in conflict with the argument that 
countries with less reliance on natural resources form better governance institutions. 
Structural reforms and human capital are not significant in explaining administrative 
quality in equation (2). However, when estimating the system by excluding private 
investment from equation (2),   the coefficient of the structural reforms and human capital 
becomes positive and highly significant38 (see Table 3 equation 4). This result seems to 
                                                 
38  When the private investment variable is eliminated form the QA equation results remain primarily the 
same. The only important change-in addition to the ones mentioned above-is that in the second case the 
coefficient of the interest rate in the private investment equation becomes significant. 
 
15
be due to the fact that the structural reforms index is correlated with private investment. 
Hence, the positive impact of private investment on administrative quality seems mainly 
due to the structural reforms which stimulate firms’ decisions to invest. This result also 
shows that the impact of human capital on private investment is indirect, considering that 
this variable exerts its influence on private investment through its effect on the 
administrative quality. On the other hand structural reforms have both a direct and an 
indirect channel to exert their influence. 
 
16
 
Table 3 Estimation Results –Quality of Administration Case (QA) 
  
Endogenous Variables 
Endogenous Variables 
Explanatory 
Variables 
Priv inv 
QA 
Priv inv 
QA 
 
(1) 
(2) 
(3) 
(4) 
QA 
2.07 
 
2.16 
 
 
(2.08)** 
 
(2.17)** 
 
Gcons 
-0.27 
0.07 
-0.26 
0.04 
 
  (-3.35)*** 
(4.07)***
(-3.36)*** 
(3.81)*** 
Priv Inv 
 
0.12 
 
 
 
 
(2.53)** 
 
 
Struct Ref 
1.71 
-0.0018 
1.73 
0.3 
 
(5.24)*** 
(-0.01) 
(5.28.)*** 
(9.11)*** 
Human Cap 
0.25 
0.05 
0.2 
0.09 
 
(1) 
(0.95) 
(0.79) 
(2.47)** 
Oil Export 
-0.03 
0.0025 
-0.04 
-0.0025 
 
(-2.96)*** 
(0.85) 
(-3.28)*** 
(-1.41) 
GDP per 
capita 
0.00009 
0.0007 
0.00018 
0.0001 
 
(0.38) 
(1.80)* 
(0.73) 
(3.12)*** 
MENA 
Dummy 
-0.97 
0.13 
-0.83 
0.02 
 
(-0.99) 
(0.67) 
(-0.86) 
(0.15) 
Realr 
-0.01 
 
-0.03 
 
 
(-1.53) 
 
(-3.18)*** 
 
Growth 
0.19 
 
0.16 
 
 
(2.77)*** 
 
(2.13)** 
 
Ten Syst 
 
0.01 
 
0.02 
 
 
(3.55)***
 
(6.21)*** 
Constant 
15.5 
-2.84 
15.62 
-1.03 
  
(10.13)*** 
          (-3.85)***
(10.16)***
(-6.65)*** 
Numb obs 
349 
349 
349 
349 
Notes: (*) indicates significance at 10 %; (**) indicates significance at 5 %; (***) indicates significance 
at 1%. 
 
4.2.2 Political Stability 
Political Stability (see columns 1and 2 of Table 4) seems to have a significant and 
positive impact on the investment decisions, but for this governance indicator the level of 
significance is 10%. This conclusion supports the view that a stable political environment 
is essential for investment.  
Once again, trade openness and financial development are confirmed to be part of 
a healthy investment climate and to stimulate private investment decisions, but this time 
their effect is indirect. Structural reforms enhance the level of investment by improving 
the political stability of a country (see Table 4 equations 1 and 2). 
 
17
              In this specification, both of the variables that are related to the neo-classical 
investment model- growth and interest rate- are highly significant with the expected 
signs, pointing out the fact that at the final stage, supply and demand considerations 
constitute major factors for the entrepreneurs to undertake a new investment project.  The 
influence of human capital on the political stability is highly significant. Hence we can 
say that the human capital variable is exerting its influence on political stability through 
its influence on structural reforms. (See equations 1 and 2 of Table 4). Similar to the   
Administrative Quality case, in this specification we are again able to verify natural curse 
hypothesis. But the effect of private investment is not significant on political stability. 
Table 4 Estimation Results – Political Stability Case  (PS) 
  
Endogenous Variables 
Endogenous Variables 
Explanatory 
Variables 
Priv inv 
PS 
Priv inv 
PS 
 
(1) 
(2) 
(3) 
(4) 
PS 
3.64 
  
3.46  
  
 
(1.72)* 
  
(1.64) 
  
Gcons 
-0.20 
-0.01 
-.21 
0.01  
 
  (-2.52)** 
(-0.49)  
           (-2.64)*** 
           (0.77) 
Priv Inv 
 
-.07 
  
 
 
 
(-1.59) 
  
 
Struct Ref 
1.11 
0.53 
1.15 
.34 
 
(1.51) 
(4.36)***           (1.57) 
(9.29)*** 
Human Cap 
-0.42 
0.25 
-.35 
0.22 
 
(-0.76) 
(5.32)** 
(-0.63) 
(5.21)*** 
Oil Export 
-0.05 
-0.001 
-0.05 
0.002 
 
(-3.02)*** 
(-0.25) 
           (-2.80)*** 
(1.15) 
GDP per 
capita 
-0.00002 
0.0002 
-0.0001 
0.0001 
 
(-0.06) 
(3.90)***
           (-0.29) 
(3.68)*** 
MENA 
Dummy 
-2.19 
.34 
-2.24 
0.40 
 
(-1.64) 
(1.81)* 
(-1.68 )* 
(2.26)** 
Realr 
-0.05 
  
-0.03 
  
 
(-2.47)** 
  
           (-1.54) 
  
Growth 
0.19 
  
0.19 
  
 
(2.53)** 
 
(3.11)*** 
 
Ten Syst 
 
0.013 
  
0.01 
 
 
(3.66)***
 
(3.37)*** 
Constant 
16.96 
-0.02 
17.00 
-1.09 
 
(7.09)*** 
(-0.02) 
(7.17)*** 
(-6.16)*** 
Numb obs 
349 
349 
349 
349 
Notes: (*) indicates significance at 10 %; (**) indicates significance at 5 %; (***) indicates significance 
at 1%. 
 
The regional MENA dummy in the political stability equation (Table 4 equation 
2) is significant with a positive sign. This result establishes a strong conclusion about the 
level of the quality of the governance in the MENA region as measured by the political 
stability indicator. Controlling for the other determinants of the political stability, being a 
 
18
MENA country increases the level of stability. This result shows that MENA region is 
politically quite stable compared to the other developing countries in our sample. Unlike 
the administrative quality case, government consumption does not have a robust effect on 
political stability (Table 4-column 2). Also the positive impact of GDP and Tenure 
system on political stability are validated in this specification.  
4.2.3 Political Accountability 
Table 5 reports the regression results when “Political Accountability” measures 
the perceived quality of institutions. We show that the coefficient of Political 
Accountability in the private investment equation (See table 5 equation 1) is significant at 
the 10% level. This can be viewed as an important contribution to the literature on 
economic activity and democracy.  This set of estimations, also confirms that structural 
reforms encourage private investment decisions. This time, the link appears to be only 
direct, the coefficient of the structural reforms indicator in the political accountability 
equation appears insignificant (Table 5 equations 1 and 2)39. Like the political stability 
case human capital has a significant influence on the political accountability but not on 
private investment. Unlike the previous indicators the MENA dummy variable has 
different coefficient in both of the equations. In equation (1), the coefficient of the 
MENA dummy is positive, although not significant. On the political accountability 
equation (equation 2) the coefficient of this variable is now significant and negative. This 
last finding strengthens our claims about the low level of democratic quality in the 
MENA region introduced in the first section.  
 
 
 
 
                                                 
39 This influence becomes both direct and indirect when the private investment is dropped from the PA 
equation. See Columns  3 and 4 of table 5 for the case where private investment is dropped from the public 
accountability equation. 
 
19
 
Table 5 Estimation Results- Political Accountability  (PA) Case 
  
Endogenous Variables 
Endogenous Variables 
Explanatory 
Variables 
Priv inv 
PA 
Priv inv 
PA 
 
(1) 
(2) 
(3) 
(4) 
PA 
4.74 
 
4.67 
 
 
(1.66)* 
 
(1.63) 
 
Gcons 
 -0.44 
0.05 
 -0.45 
 0.06 
 
 (-2.45)** 
           (2.55)** 
(-2.48)** 
 (4.36)*** 
Priv Inv 
  
-0.05 
  
  
 
  
          (-0.87) 
  
  
Struct Ref 
3.53 
-0.13 
3.53 
-0.25 
 
          (4.66)*** 
(-0.98) 
          (4.67)*** 
(-5.98)*** 
Human Cap 
-0.71 
0.25 
-0.70 
0.24 
 
          (-1.00) 
(4.70)*** 
          (-0.99) 
(4.92)*** 
Oil Export 
-0.06 
0.001 
-0.06 
0.003 
 
          (-3.06)*** 
(0.33) 
          (-3.07)*** 
(1.31) 
GDP per 
capita 
-0.0008 
0.0003 
-0.0008 
0.0002 
 
            (-0.95) 
(5.64)*** 
           (-0.96) 
(5.85)*** 
MENA 
Dummy 
4.47 
-1.15 
4.37 
-1.11 
 
           (1.25) 
          (-5.27)*** 
          (1.22) 
(-5.42)*** 
Realr 
-0.04 
  
-0.03 
  
 
           (-2.86)*** 
  
           (-3.11)*** 
  
Growth 
0.23 
  
0.19 
  
 
           (2.77)*** 
  
           (2.75)*** 
  
Ten Syst 
  
0.01 
  
0.01 
 
            
(2.29)*** 
          
(2.21)***  
Constant 
17.35 
-0.25 
17.63 
-0.95 
 
           (6.80)*** 
 (-0.30) 
           (6.97)***  
(-4.70)***  
Numb obs 
349 
349 
349 
349 
Notes: (*) indicates significance at 10 %; (**) indicates significance at 5 %; (***) indicates significance 
at 1%. 
 
Once again both of the variables that are related to the neo-classical investment 
model- growth and interest rate- are highly significant with the expected signs. Like the 
political stability and administrative quality cases, crowding out effect of the government 
sector spending on private investment and the positive influence of government 
consumption on the quality of institutions is established in this specification too (Table 5 
equations 1 and 2). Finally like the previous two indicators, this one also verifies the 
natural curse hypothesis along with the positive influence of the level of GDP on 
governance.  
 
20
5. Perceived Quality of Governance and Private Investment Performance of 
MENA 
In this section, we use the models estimated previously to uncover the 
contribution of each type of governance institution to the improvement of private 
investment performance in the MENA region. We evaluate, in particular, the contribution 
of the “Administrative Quality”, “Political Stability” and, “Political Accountability”, 
which have proved to exert primary importance in explaining firm’s decision to invest. 
For this purpose, we compare private investment performance of the MENA region in 
these respects to the one of the more advanced developing economies of our sample, the 
East Asian economies.  
We simulate which level of private investment MENA could have achieved if the 
region had the same perceived governance institutions as East Asia. This is done for two 
time periods – the 1980s and the 1990s respectively – which display, as we will see, quite 
different characteristics. In our simulations we use the first equations obtained for private 
investment in the three different specifications. (See the first columns of Tables 3, 4 and 
5). The contribution of the Quality of Administration index has been calculated by 
aggregating the contributions of its four sub-components and the same thing has been 
done for Political Stability and Political Accountability. Hence, to get the overall impact 
of the changes in each category of the governance indicators, we first had to calculate the 
contribution of each initial variable in the category to the overall improvement in the 
level of private investment. The calculation is based on the estimated coefficients of each 
type of governance indicator in the regression (Table 3-1, Table 4-1 and Table 5-1), as 
well as on the weights of each principal component in the aggregate indicator combined 
with the loading of the initial variables in each principal component (Annex 2)40. 
Coefficients of the initial variables are presented in Annex 3 and their contributions 
appear in Tables 6, 7 and 8. 
The weaknesses of MENA institutions during the 1980s are uncovered by the first 
set of results. From Table 6 (top section) it can be seen that, if MENA had the same 
perceived quality of administration as the East Asia in the 1980s it’s average-private 
investment to GDP ratio would have reached 13.8 (compared to 11.9 per cent 
observed).When the contributions of the various components of administration quality  to 
this result are examined, it becomes clear that deficiencies in the investment profile and 
law &order were the primary reasons for the gap between the actual and potential level of 
private investment (these two components are responsible for the loss of 0.6 and 0.8 
points of private investment to GDP respectively). These results imply that, in the 1980s 
the countries in the MENA region had difficulties in ensuring an equitable and consistent 
rule of law in protecting the security rights, as well as providing an investment 
environment that is free from risks to operations and excessive regulations.  
 
                                                 
40 See for example, Nagaraj et ali. (2000) for more details on the methodology. 
 
21
 
Increase in private investment in this decade would have been even more if the 
same level of “Political Stability” and “Political Accountability” could have been attained 
as the East Asian countries. Table 7 shows that in the 1980s, private investment in the 
MENA region had the potential to reach on average 15.9 per cent of GDP if the gap with 
the East Asian institutions in terms of political stability was diminished. External and 
internal stability components were nearly the sole contributors to this result which have 
reduced private investment decisions by respectively 1.6 and 2.7 per cent of GDP on 
average per year41 If MENA had benefited from the same quality political accountability 
private investment would have been 15.9 percent of GDP in the 1980s (See table 8). The 
lack of civil liberties and political rights has both been important factors in keeping the 
region from reaching its potential level of investment. 
 
 
In the 1990s, the gap with East Asia has been noticeably reduced and 
improvement of the “Administrative Quality” and “Political Stability” notably helped 
investments decisions. The deficit in private investment caused by insufficient quality of 
administration was 0.4 points of GDP on average per year in the 1990s (see Table 6 
bottom section). The gap with East Asia has nearly fully diminished in terms of 
corruption, investment profile and law &order. On the other hand just like the 1980s lack 
of bureaucratic quality is still responsible for the loss the private investment equaling to 
0.3 points of GDP on average. In the 1990s, MENA had a superior performance –as 
measured by the overall political stability indicator- than the East Asia in terms of 
                                                 
41 From table 7 it can be seen that in the 1980’s the level of ethnical tensions were lower in the MENA 
compared to the East Asian countries. 
Table 6 Private Investment to GDP – Administrative Quality (QA) Case 
 
 
Increase with an improvement in 
 
  
Priv. Invest. 
(Actual) 
QA Corruption 
Bur. 
Qual. 
Invest.Prof. 
Law& 
Order 
Priv Invest. 
(Potential) 
1980 
11.9 
1.9 
 
 
 
 
13.8 
 
 
 
0.2 
0.3 
0.6 
0.8 
 
 
 
 
 
 
 
 
 
1990 
11.6 
0.4 
 
 
 
 
12.0 
  
 
 
0.0 
0.3 
0.0 
0.1 
 
Source: Authors’ calculations. 
Table 7 Private Investment to GDP – Political Stability (PS) Case 
 
 
Increase with an improvement in 
 
  
Priv. Invest. 
(Actual) 
PS 
Gov. Stab. 
Int. 
Confl. 
Ext. Confl. 
Ethn. Tens. 
Priv Invest. 
(Potential) 
1980 
11.9 
4.0 
 
 
 
 
15.9 
 
 
 
0.1 
1.6 
2.7 
-0.4 
 
 
 
 
 
 
 
 
 
1990 
11.6 
-0.7 
 
 
 
 
10,9 
  
 
 
-0.6 
0.1 
0.3 
-0.5 
 
Source: Authors’ calculations. 
 
22
political stability (see Table 7). Government stability and ethnic tension sub-components 
are better for the MENA region, whereas- although improved significantly compared to 
the 1980- external conflict still accounts for the loss of 0.3 points of private investment to 
GDP.  
 Things are different on the political accountability side. It seems like the gap 
between the two regions did not decrease at all in terms of this variable. The low level of 
perceived political accountability is responsible for the deficit in private investment 
equaling to 3.9 points of GDP (See Table 8). Like 1980s the contribution of political 
rights and civil liberties to this aggregate effect is 1.9 and 2.1 points. 
 
  
These results confirm that the MENA region could have achieved a better private 
investment performance if it had an enhanced level of perceived institutions. They also 
underlie the fact that governance may exert different levels of influence on private 
investment when measured by different indicators. Generally speaking, the low level of 
political accountability has been a persistent factor which has been holding back the 
region from reaching its private investment potential42.  
6. Conclusion 
 
Governance is a wide-ranging phenomenon and its distinct features exhibit quite 
different states in terms of governance institutions for the same region. In this paper we 
empirically show that the perceived quality of governance is an important determinant of 
the private investment decisions in the developing countries by stressing the existence of 
different types of possible measures of governance.  
Investors do not have perfect information about the current and future states of the 
governance institutions. Perceptions about the quality of governance are crucial for 
private investment decisions. Our data set -which is obtained from independent private 
firms that provide consulting services to international investors - captures this “perceived 
quality of governance” phenomenon. We use a simultaneous equations model to account 
for the reverse causality between the various types of governance indicators, namely 
“Quality of Administration” (QA), “Political Accountability” (PA) and “Political 
                                                 
42 We acknowledge the fact that the lack of other types of governance indicators was also effective in the 
determination of the level of private investment in the MENA region (especially some sub-components of 
the indicators). But in terms of magnitude and consistency of the effect, political accountability seems to be 
the most influential one among the three indicators of governance.  
Table 8 Private Investment to GDP – Political Accountability (PA) Case 
 
 
Increase with an improvement in 
 
  
 
Priv. Invest. 
(Actual) 
PA 
Pol. Rights 
Civ. Lib. 
Priv Invest. 
(Potential) 
1980 
11.9 
4.0 
 
 
15.9 
 
 
 
1.9 
2.1 
 
 
 
 
 
 
 
1990 
11.6 
4.0 
 
 
15.6 
 
 
 
1.9 
2.1 
 
Source: Authors’ calculations. 
 
23
Stability” (PS), and private investment. In our empirical model, endogenous variables are 
the share of private investment and the various measures of governance. When using this 
model we controlled for the other determinants of private investment and governance 
indicators as well. Different types of governance institutions are confirmed to exert their 
influence on private investment through diverse mechanisms. All of the three indicators 
were proven to be significantly –although at different levels of significance and 
magnitudes of influence-important for private investment decisions. “Administrative 
Quality” was significant at the 5% significance level while the Political Accountability 
and Political Stability were significant at 10%. The validation of the influence of 
Administration quality confirms that a low level of perceived corruption, risks to 
operations, taxation procedures and labor costs and the protection of security rights by the 
enforcement of the laws are crucial for the investment friendly environment in the 
developing countries. Also we provide empirical evidence for the view that political 
stability can enhance private investment decisions by providing a stable environment and 
decreasing the level of uncertainty. Moreover, we present an important piece of evidence 
which can be useful for the ongoing debate about the role of democratic institutions on 
economic activity. Our results confirm that an open and participatory political system 
provides stability of social institutions and ensures a broad political support to policies, 
which are in this case more sustainable in the long run. In particular civil liberties and 
political rights can help the government to build credibility. 
 The weakness of MENA institutions during the 1980s was an important reason 
for the observed low level of investment in this region. If MENA had the same perceived 
quality of administration as the East Asia in the 1980s, its average-private investment to 
GDP ratio would have reached 13.8 instead of the observed 11.9 per cent. In the 
Administration Quality compartment, investment profile and law &order were the 
primary reasons for the gap between the actual and potential level of private investment. 
These results imply that, in the 1980s the countries in the MENA region had difficulties 
in ensuring an equitable and consistent rule of law in protecting the security rights, as 
well as providing an investment environment that is free from risks to operations and 
excessive regulation. The impact of closing the gap with East Asia in terms of “Political 
Stability” and “Political Accountability” on private investment would have been even 
more. If political stability was enhanced, private investment in the MENA region had the 
potential to reach on average 15.9 per cent of GDP in this decade. External and internal 
stability components were nearly the sole contributors to this result. If MENA had 
benefited from the same quality political accountability private investment would have 
been 15.9 percent of GDP in the 1980s. The lack of civil liberties and political rights has 
both been important factors in keeping the region from reaching its potential level of 
investment. 
In the 1990s the gap between the two regions mostly diminished in terms of the 
quality of the administration and political stability. The deficit in private investment 
caused by insufficient quality of administration was 0.4 points of GDP on average per 
year in the 1990s compared to 1.9 in the 1980s. In this decade, MENA had a superior 
performance –as measured by the overall political stability indicator- than the East Asia 
in terms of political stability. Government stability and ethnic tension sub-components 
 
24
were better for the MENA region, whereas- although improved significantly compared to 
the 1980- external conflict still accounted for the loss of 0.3 points of private investment 
to GDP. On the other hand the gap between the two regions did not decrease at all in 
terms of the political accountability.  The low level of perceived political accountability 
is responsible for the deficit in private investment equaling to 3.9 points of GDP. 
 These results confirm that the MENA region could have achieved a better private 
investment performance if it had an enhanced level of perceived institutions. They also 
underlie the fact that governance may exert different levels of influence on private 
investment when measured by different indicators. However, the low level of political 
accountability has appeared to be the most persistent and influential factor which has 
been holding back the region from reaching its private investment potential. 
 
                                                 
 
25
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Annex 1 
 
List of Countries  
 
List of Countries with High Quality Data (63 countries) 
 
 
Argentina 
Kenya* 
Bangladesh* 
Lithuania 
Barbados* 
Malawi* 
Belize 
Malaysia* 
Benin* 
Mauritius* 
Bolivia* 
Mexico 
Brazil* 
Moldova 
Bulgaria 
Morocco 
Cambodia 
Namibia 
Chile* 
Pakistan* 
China* 
Panama 
Colombia* 
Papua New Guinea* 
Comoros 
Paraguay* 
Costa Rica* 
Peru* 
Cote d'Ivoire 
Philippines* 
 
31
Croatia 
Poland* 
Dominican Rep. 
Romania 
Ecuador* 
Serbia and Montenegro 
Egypt, Arab Rep.* 
Seychelles 
El Salvador 
South Africa* 
Estonia 
St Lucia 
Ethiopia 
St. Lucia 
Guatemala* 
St. Vincent and the Grenadines 
Guinea-Bissau 
Thailand* 
Guyana 
Trinidad & Tobago* 
Haiti 
Tunisia* 
Honduras* 
Turkey* 
India* 
Uruguay* 
Indonesia* 
Uzbekistan 
Iran, Islamic Rep. 
Venezuela* 
 
Yugoslavia (FR) 
 Due to the lack of corresponding data for some countries, only counties marked 
with * are included in the final regressions 
 
 
32
Annex 2  
Principal Component Analysis 
 
Table A.2.1: The Administrative Quality Indicator 
 
Component 
Eigenvalue 
Cumulative R2  
P1 
2.23 
0.56 
P2 
0.83 
0.76 
P3 
0.51 
0.89 
P4 
0.43 
1 
 
 
Loadings 
P1 
P2 
P3 
P4 
Corruption 
0.49 
-0.57 
0.06 
0.65 
Bureaucracy Quality 
0.54 
-0.08 
0.64 
-0.54 
Investment profile 
0.41 
0.81 
0.08 
0.40 
Law and Order 
0.54 
-0.02 
-0.76 
-0.36 
 
QA = P1*(0.5577/0.7640) + P2*(0.2063/0.7640) 
 
 
Table A.2.2: The Political Stability Indicator 
 
Component 
Eigenvalue 
Cumulative R2  
P1 
2.96 
0.42 
P2 
0.97 
0.56 
P3 
0.90 
0.69 
P4 
0.68 
0.79 
P5 
0.62 
0.88 
P6 
0.57 
0.96 
P7 
0.30 
1 
 
 
Loadings 
P1 
P2 
P3 
P4 
Gov Stability) 
0.32 
-0.62 
-0.38 
0.05 
Socioeco Conditions 
0.29 
0.63 
-0.44 
-0.14 
Internal Conflicts  
0.51 
-0.06 
-0.09 
-0.07 
External Conflicts  
0.39 
-0.29 
0.26 
-0.6 
Ethnic Tensions 
0.39 
-0.06 
0.02 
0.77 
Religious Tensions 
0.31 
0.19 
0.76 
0.1 
Military in Politics 
0.39 
0.31 
-0.12 
-0.11 
 
PS = P1* (0.4253/ 0.7878) + P2* (0.1373/0.7878) + P3* (0.1280/ 0.7878 + P4* (0.0972/ 0.7878) 
 
 
 
33
Table A.2.3.: The Political Accountability Indicator 
 
Component 
Eigenvalue 
Cumulative R2  
P1 
1.88 
0.94 
P2 
0.12 
1 
 
 
 
Loadings 
P1 
P2 
 
Political Rights  
0.71 
0.71 
 
Civil Liberties 
0.71 
-0.71 
 
PA = P1 
 
Annex 3 
 
Table A.3.1 : Short term coefficients of the Disaggregated  
Indicators  
Short and Long Term Coefficients/Elasticities 
  
  
  
  
Short Term Coefficients 
Standardized 
Level 
Index 
Variables 
Variables 
Variables 
corruption 
0,43 
0,40 
bureaucraty quality 
0,78 
0,75 
QA 
investment profile* 
1,08 
0,51 
 
law and order 
0,80 
0,62 
  
  
  
  
Government 
Stability  
1,81 
0,75 
PS 
Internal Conflict  
1,56 
0,60 
 
External Conflict 
1,49 
0,67 
 
Ethnic Tensions  
0,67 
0,46 
 
  
  
  
Political rights 
3,37 
1,70 
Civil liberties 
3,37 
2,10 
PA