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Worldwide Governance Indicators and key Findings: Implications for Credit, Investment

and Policies in Emerging Markets

Daniel KaufmannThe World Bank Institute

www.worldbank.org/wbi/governanceor, www. govindicators.org

Presentation at Conference on ‘Political Risk Revisited’, at Chatham House,

London, February 5th, 2007

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Evidence-based Approach, through empirics

1. Data Matters--on Governance & Institutions: data can be gathered, analyzed, and used judiciously

2. Institutions, Governance and Corruption Matters 3. On average stagnation on Governance – yet high

variance --some countries improve in short term4. Behavior of the Firm and Investor also Matters5. Global collective responsibility6. Governance matters for a country’s: growth,

competitiveness, investments & financial markets7. Implications for Political Risk Analysis & Sectoral Policy

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The ‘Power of Data’: progress in measurement

1. The ‘Macro’/Aggregate Level of Measurement:

Worldwide Aggregate Governance Indicators: 200

countries, 6 components, periodic.

2. ‘Mezzo’: Cross-Country Surveys of Enterprises

3. ‘Micro’: Specialized, in-depth, in-country Governance

and Institutional Capacity Diagnostics: Includes surveys

of: i) user of public services (citizens); ii) firms, and, iii)

public officialsOn ‘Aggregate/Macro’ Level first…

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Six Dimensions of Governance Measured

• The process by which those in authority are selected and replaced [Political Governance]: 1. VOICE AND ACCOUNTABILITY 2. POLITICAL STABILITY & ABSENCE OF

VIOLENCE/TERRORISM• The capacity of government to formulate & implement

policies, and deliver services [Economic Governance]:3. GOVERNMENT EFFECTIVENESS4. REGULATORY QUALITY

• Respect of citizens and state for institutions that govern interactions among them [Institutional Governance]: 5. RULE OF LAW 6. CONTROL OF CORRUPTION

Governance as the set of traditions and institutions by which authority in a country is exercised -- specifically:

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2006 Worldwide Governance Indicators: Key Features after a decade of Governance Data

• Widely used by policymakers and researchers to study causes and consequences of good governance– biannual data since 1996, now annual data

• Based on 31 data sources from 25 organizations, capturing views of thousands of informed stakeholders

• Covering over 213 countries & territories, estimate of 6 dimensions of governance and of margins of error

• Now also: access to individual data underlying the construction of the aggregate indicators– hundreds of individual indicators over past decade– very large on-line governance data resources,

at www.govindicators.org

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Sources of Governance Data• Cross-Country Surveys of Firms: Global Competitiveness

Survey, World Business Environment Survey, World Competitiveness Yearbook, BEEPS

• Cross-Country Surveys of Individuals: Gallup International Voice of the People, Latinobarometro, Afrobarometer

• Expert Assessments from Commercial Risk Rating Agencies:DRI, PRS, EIU, World Markets Online, Merchant International Group, IJET Travel Consultancy, PERC

• Expert Assessments from NGOs, Think Tanks: Reporters Without Borders, Heritage Foundation, Freedom House, Amnesty International, Bertelsmann Foundation, Columbia University, International Research and Exchanges Board

• Expert Assessments from Governments, Multilaterals: World Bank CPIA, EBRD, AFDB, ADB, State Dept. Human Rights Report, Trafficking in Persons Report

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Building Aggregate Governance Indicators• Benefits from Aggregation• Use Unobserved Components Model (UCM)

to construct composite governance indicators, and margins of error for each country

• Estimate of governance: weighted average of individual scores for each country, re-scaled

• Weights are proportional to precision of underlying data sources, and precision based on extent of ‘consensus’ among sources

• Margins of error reflect (a) number of sourcesin which a country appears, and (b) the precision of those sources

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Control of CorruptionSelected Countries, 2005

-2.5

0

2.5E

Q. G

UINE

A

SO

MA

LIA

HAI

TI

MY

AN

MA

R

SU

DAN

PA

RAG

UAY

CAM

ER

OO

N

CA

MBO

DIA

KE

NYA

CHIN

A

MEX

ICO

IND

IA

BR

AZIL

GR

EE

CE

ITAL

Y

SLO

VA

K RE

PUB

LIC

KO

REA

, SO

UTH

SO

UTH

AFR

ICA

HUN

GAR

Y

URU

GUA

Y

ES

TON

IA

SLO

VEN

IA

BO

TSW

ANA

JAPA

N

CHIL

E

UNI

TED

STA

TES

DEN

MAR

K

NEW

ZEA

LAN

D

SING

AP

OR

E

FIN

LAN

D

ICE

LAN

D

Poor Governance

Governance Level

Margins of Error

Good Governance

Source for data: 'Governance Matters V: Governance Indicators for 1996-2005’, D. Kaufmann, A. Kraay and M. Mastruzzi, September 2006.Note: Colors are assigned according to the following criteria: Dark Red, below 10th percentile rank among all countries in the world; Light Red between 10th

and 25th; Orange, between 25th and 50th; Yellow, between 50th and 75th; Light Green between 75th and 90th; Dark Green above 90th.

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Are Countries Stagnating in Governance?

• The world on average has not improved on governance, though it has on the macro-economic policies, infrastructure, etc: there is a ‘governance gap’

• But large or small variation across countries?

• New method: for each country, we can identify whether there are significant changes over time

• It is found that changes can take place in the short-term: in 6-to-8 years, some deteriorations as well as some significant improvements as well

10

0

1.5

3

1984-1988 1989-1993 1994-1998 1999-2001

TRANSITION

EMERGING

OECD+NIC

Source: ‘Rethinking Governance’, based on calculations from WDI. Y-axis measures the log value of the average inflation for each region across each period

Significant Decline in Inflation Rates WorldwideHighInflation

Low

(avg. inlogs)

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Quality of Infrastructure also improved…

1.5

4

6.5

1997 1998 1999 2000 2001 2002 2003

High

Low

East AsiaIndustrialized

OECD

Transition

Emerging

Source: EOS 1997-2003 (Quasi-balanced panel). Question 6.01: General infrastructure in your country is among the best in the world?

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But by contrast, governance has stagnated…Judiciary Independence (EOS survey resuls 1998-2004)

1

4

7

1998 1999 2000 2001 2002 2003 2004

Inde

pend

enci

a de

la J

udic

atur

a

OECD

East Asian NICs

Latin America

NON OECD

HighIndependence

No Independence

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No Significant Trend in Control of Corruption Worldwide Averages

0.2

0.5

0.8

1996 1998 2000 2002 2004

EIU

PRS

QLM

Poor

Good

PRS country coverage in 1996: 129, all other periods 140; QLM and EIU country coverage: 115 for all periods.

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Press Freedom in the World, 1995 vs. 2004: Stagnant?

32

34

34

Not Free

Part Free

Free

% countries in 1995

Source: Freedom House. Y axis measures percentage of countries in the region with free press (rating of 30 or below), partly free (ratings between 30 and 60) and not free (rating above 60).

36

26

38

Not Free

Part Free

Free

% countries in 2004

15

-2

0

2IV

OR

Y CO

AST

ZIM

BABW

E

ISRA

EL

NAM

IBIA

EG

YPT

CAM

BOD

IA

LAO

S

RO

MAN

IA

CAM

ERO

ON

PAK

ISTA

N

RUSS

IA

GHA

NA

BO

LIV

IA

BOTS

WAN

A

SPA

IN

BULG

ARIA

ESTO

NIA

LATV

IA

Major Deterioration

(selected countries)

Major Improvement

(selected countries)

Insignificant Change (selected countries)

Changes in Control of Corruption, 1996-05

Changes were calculated on the basis of the differences in country estimates from 1996 and 2005. Classification for major deteriorations and improvements were based on 75% confidence interval. Source for data: 'Governance Matters V: Governance Indicators for 1996-2005’, by D. Kaufmann, A.Kraay and M. Mastruzzi, September 2006 - www.govindicators.org

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Development Dividend From Good Governance

Low Governance Medium Governance High Governance

Control of Corruption

$300

$3,000

$30,000

Data Source for calculations: KK 2004. Y-axis measures predicted GDP per capita on the basis of Instrumental Variable (IV) results for each of the 3 categories. Estimations based on various authors’ studies, including Kaufmann and Kraay.

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Good Governance associated Country’s Competitiveness

ZWE

VNMVEN

URY

USA

GBRARE

UKR

UGA

TUR

TUN

TTO

THA

TZA

TJK

TWNCHE

SWE

LKA

ESP

ZAF

SVN

SVK

SGP

YUG

RUS

ROM

QATPRT

POL

PHLPER

PRY

PAN

PAK

NOR

NGA

NIC

NZLNLD

NAM

MOZ

MAR

MNGMDA

MEXMUS

MLT

MLI

MYS

MWI MDG

MKD

LUX

LTULVA

KGZ

KWT

KOR

KEN

KAZ

JOR

JPN

JAM

ITA

ISR IRL

IDN

IND

ISL

HUN

HKG

HND

GUY

GTM

GRC

GHA

DEU

GEOGMB

FRA

FIN

ETH

SLVEGY

ECU TMPDOM

DNK

CZECYP

HRV CRICOL

CHN

CHL

TCD

CAN

CMRKHM

BGR

BRA

BWA

BIHBOL

BEN

BEL

BGD

BHR

AZE

AUT

AUS

ARGDZA

ALB

2

4

6

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0WGI Control of Corruption

Gro

wth

Com

petit

iven

ess

Inde

x (E

OS)

LowLow High

High

r = 0.90

Sources: GCI drawn from EOS firm survey, WEF 2005 – 117 countries; Control of Corruption from Kaufmann, Kraay and Mastruzzi, ‘Governance Matters IV: Governance Indicators for 1996-2004’.

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Constraints to Business vary across regions & countries (responses from the Firm in EOS 2005)

0

10

20

30

40

50

60

70

Chile East Asia NICs East Asiadeveloping

Sub-saharanAfrica

Latin America

Infrastructure Bureaucracy CorruptionTax Regulations Inflation

% firms reporting constraint among top 3:

Source: EOS 2005. The question posed to the firm was: Select among the above 14 constraints the five most problematic factors for doing business in your country. Note that the overall EOS sample covers 120 [CHECK] countries, and in some regions –particularly in the Middle East, Africa and the FSU, many countries are not surveyed. Thus, regional averages need to be interpreted with caution, since typically countries not surveyed tend to rate lower in governance than those surveyed.

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0

20

40

60

80

100

OECD East Asia(NIC)

East Asiadev.

South Asia Sub-saharanAfrica

FormerSovietUnion

EasternEurope

LatinAmerica

Freq

uenc

y of

Bri

bery

Connection to Utilities Taxation Procurement

Judiciary State Capture

Unbundling Corruption: Different types of Bribery(responses by firms 2005)

% Firm Report High Bribery (1-3)

Source: EOS firm survey, WEF2005 – 117 countries. Question: In your industry, how commonly firms make undocumented extra payments or bribes connected with permits / utilities / taxation / awarding of public contracts / judiciary? (common…never occurs).

Bribery in:

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Multinationals Bribe Abroad?% Firms Reporting Frequent Procurement Bribery, EOS 2005

0

20

40

60

80

100

Procurement Bribery is prevalent (% Firms Report)% F

irm

s Rep

ortin

g Pr

ocur

emen

t Bri

bery

is P

reva

len Domestic Firm in OECD Country

OECD Multinational in another OECD country

OECD Multinational in Non-OECD country

Domestic Firm in Non-OECD Country

Source: EOS, preliminary. Question: In your industry, how commonly would you estimate that firms make undocumented extra payments or bribes connected with the following: permits, public utilities, tax payments, loan applications, awarding of public contracts, influencing of laws, policies, regulations and decrees to favor selected business interest, and judicial decisions. Any firms reporting answers 1 through 3 were considered to be reporting at least high frequency of bribery, while answers 4 through 7 were not.

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Governance Matters for Assessing Emerging Financial Markets Prospects

Indicators Matter, and Some Empirical Lessons

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Stock Market Volatility vs. Control of Corruption

ARG

BRA

CHL

CHN

COLCZE

EGYFRA

GRC

HKG

HUN

IND

IDN

ISRITA JPN

JOR

KORMYS

MEX

MAR

NGA

PERPHL

POL

PRT

RUS

SAU

SVKZAF

ESP

LKA

TWN

THA

TUR

USA

VEN

ZWE

0

10

20

30

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0Control of Corruption

Stoc

k M

arke

t Vol

atili

ty

LowLow High

High

r = -0.56

Sources: KK 1998 and Morgan Stanley Capital International Dataset and Emerging Markets Database (1998). Stock volatility defined as the standard deviation of monthly returns over December 1984 to December 1998, multiplied by 100.

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Opacity (or misgovernance) affects Herding (investors mimic each other’s behavior)

ofactor20 30 40 50 60

.05

.1

.15

Herding

Opacity (Misgovernance)Gelos and Wei, 2005

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Misgovernance Higher Fragility of Financial Sector Soundness of Banks vs. Control of Corruption

(View of the firm, GCS 2001)

3

5

7

Poor Control ofCorruption

Average Control ofCorruption

Good Control ofCorruption

Average Uncontrolled Rating

Predicted Controlled Value

Soundness of Banks

Low

Source: Global Competitiveness Survey, 2001, KK Governance Indicators

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2006 Bond Spreads vs. Corruption Control

Venezuela

UruguayTunisia

Thailand

Korea, sout h

Sout h Af r ica

Russia

PolandPhil ippines

Peru

Pakist an

Niger ia

Morocco

Mexico

Malaysia

Lebanon

Hungary

El Salvador

Egypt

Ecuador

Dominican Republic

Ivory Coast

Colombia

ChinaChile

Braz il

Argent ina

-2 -1 0 1 2Control of Corruption (KK05)

Bon

d Sp

read

s (lo

g - B

FS06

)

40

400

4,000

125

1,250

Low Control High Control

Sources: Bloomberg Financial Services & WBI. Bond spreads are drawn from the Global Emerging Market Bond Index (EMBIG) produced by JP Morgan on 33 emerging economies.

r = - 0.57

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Summary and Implications1. Governance measurement skepticism challenged2. Misgovernance as one binding constraint nowadays3. Beyond corruption: governance more broadly4. Beyond administrative corruption -- influence

peddling and state capture by firms is also key5. Governance Matters for country growth prospects,

for Investments, and for financial markets6. Misgovernance affects: fragility of financial markets

& banks, volatility of equity markets; investor herding behavior (& lower I); bond market spreads

7. Capital Market Development: Disciplining for GG8. Assessing & Measuring Governance key for Political

Risk assessment9. Good Governance & Transparency at Sectoral Level10. Global Challenges and Responsibility

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Governance Has Improved in Some Groups:e.g. “Pull Effect” of EU Accession

-1.5

-1

-0.5

0

0.5

1

1996 1998 2000 2002 2004

Rul

e of

Law

EUAccessed

ex-SovietUnion (noaccess)

Source for data: http://www.worldbank.org/wbi/governance/govdata/. EU EE Accessed Countries: Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, and Slovenia.

High

Low

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Governance Indicators: Chile, 2004 vs. 1996

Source for data: http://www.worldbank.org/wbi/governance/govdata2002 ; Colors are assigned according to the following criteria: Dark Red, bottom 10th

percentile rank; Light Red between 10th and 25th ; Orange, between 25th and 50th ; Yellow, between 50th and 75th ; Light Green between 75th and 90th ; Dark Green above 90th.