Why Some Countries Trade More than Others: The Effect of the Governance Environment on Trade Flows

Abstract

In addition to trade policies, governments must pay attention to the governance environment to evaluate their own and their trading partners' trading environment. When selecting trading partners, a firm needs to consider the prospective trading partner's characteristics (such as reputation, resources, and so forth), the trade policies of the partner's country, and the governance environment of that country. This study refines and extends institutional theory and contributes to both governance and trade literatures by distinguishing two governance environments and how they affect trade flows between countries.Examining trade patterns among 44 countries representing 89 per cent of world trade, we find that overall, rule-based countries trade more than relation-based countries. Countries with a large gap in governance environments tend to trade less. A positive effect on trade flows exist between two highly rule-based countries, but not between two highly relation-based countries. Any trade relationship involving a relation-based country negatively affects trade flows. We study why some countries trade more than others by examining the effect of governance environment on trade flows between countries. We argue that countries with highly rule-based governance environments are relatively easy to trade with their transparent regulations and fair rules. In contrast, countries with highly relation-based governance environments are more difficult and/or more costly to trade with and therefore tend to have smaller trade flows.