Beyond Institutional Quality: The Role of Public Governance Heterogeneity in the Economic Growth of Transition Economies

The impact of institutional quality on the overall economic performance of a nation has been a key area of study under the broader framework of growth theory. While the traditional neoclassical models have largely focused on capital accumulation and labor as the driving forces of economic growth, the modern theories have placed a strong emphasis on the quality of institutions in the overall framework of economic growth. In their study, Acemoglu et al. [14] have pointed out that the quality of institutions, especially in the context of property rights and the regulation of rent-seeking behavior, is a fundamental factor in the context of economic growth. The empirical literature has attempted to measure institutional quality through composite indicators; the most prominent one is the Worldwide Governance Indicators (WGI) proposed by Kaufmann et al. [15]. This indicator, which covers dimensions like rule of law, control of corruption, government effectiveness, and regulatory quality, has become a widely accepted practice in cross-country growth regressions. The literature has established a positive relationship between institutional quality and economic growth. For example, Cooray [16] established that better governance leads to higher productivity of expenditure, while Méndez-Picazo et al. [17] highlighted that development in institutional quality contributes significantly to economic performance.

Kida et al. [18] found that foreign imports and domestic consumption significantly influence the GDP growth rate of Kosovo. Nevertheless, recent literature suggests that the reliance on aggregated institutional measures may conceal the underlying heterogeneity of the dimensions of governance. In this respect, the analysis of individual components allows for a more nuanced comprehension of the impact of particular institutional mechanisms on growth. In a study of the European transition economies, Bayar [4] conducted a panel analysis, which revealed that the majority of the governance measures have a significant impact on GDP growth; however, the significance of the measures differs. In particular, the rule of law and control of corruption have the most significant impact, whereas the impact of regulatory quality is less significant. This heterogeneity is further supported by more recent empirical contributions. In fact, in her recent contribution, Azimi [19] showed the presence of a long-run relationship between governance and economic growth, but she stresses the complexity of the interaction between the various components of good governance. Moreover, it has also been found that the effects of good governance could vary according to the degree of development of the economy, the level of institutional development, and macroeconomic stability. Among the different aspects of governance, the issue of corruption has attracted much attention in the literature. In this context, the study of Mauro [20] proves the adverse impact of corruption on investment and economic growth. In particular, it is argued that the adverse impact of corruption on the economy stems from the distortion of the allocation of resources and the resulting uncertainty. In a subsequent study, Mo [21] quantified the impact of corruption on the economy, proving that it affects economic growth both directly and indirectly through political instability. In a more recent study, Gründler and Potrafke [9] verified the consistency of the above results using different datasets. In the meantime, the role of government effectiveness and quality of regulation has also been recognized as important mechanisms through which institutions affect the economy. Government effectiveness refers to the quality of public services, whereas the quality of regulation refers to the capacity of governments to formulate sound policies conducive to private sector development. Gani [22] and Fayissa and Nsiah [23] have established the significance of effective governance in boosting economic growth, especially in developing economies. Nevertheless, the empirical evidence regarding the impact of RQ is inconclusive, especially in the context of transition economies. This implies that the impact of institutional reforms may be lagging. Thus, the need for a separate analysis of each component of governance, rather than a composite index, becomes evident. Besides the institutional factors, the broader macroeconomic environment is also of great importance in the analysis of growth dynamics. In this context, the following macroeconomic factors have been recognized as important determinants of economic growth: FDI, GCF, trade openness, and inflation. Among these factors, it is evident that the effectiveness of the above factors depends on the quality of governance. In this context, the study conducted by Njangang and Nawo [24] clearly proves that good governance augments the effectiveness of FDI in promoting economic growth. Thus, FDI plays an important role in economic growth of transition economies, provided that there is a strong framework in place to support this process. According to Ibraimi et al. [25], Western Balkan economies have been able to decrease corruption and enhance the environment for FDI due to efficient FDI legislation and the rule of law. In addition, empirical research conducted on the Western Balkan states shows that macroeconomic variables like remittances, FDI, and corruption significantly influence economic growth. Particularly, combating corruption and efficient management of foreign funds are crucial for ensuring economic growth in developing economies [26].

According to Fetai et al. [27], FDI, domestic credit, and savings increase economic growth, while corruption, unemployment, and government consumption reduce economic growth in the Western Balkans. Moreover, Kida et al. [28] established that market size and lower cost of conducting business have strong influences on FDI.

More recently, the literature has expanded to include sustainability aspects, which have linked governance with environmental and energy-related outcomes. Effective institutions are critical in implementing environmental policies, encouraging the use of renewable energy, and fostering sustainable resource use. Emerging literature shows that effective governance has a positive effect on sustainable and inclusive growth, while macroeconomic volatility and environmental damage have negative effects. This approach is of particular interest in the context of transition economies, as they are characterized by institutional weakness, reform processes, and substantial structural changes.

However, there are still some gaps in the literature. Firstly, the majority of the literature focuses on aggregated measures of governance, and there is a possibility that the individual impacts of different dimensions of institutions might be neglected. Secondly, there is a scarcity of literature that focuses on the group of economies in transition, especially in the context of sustainability and energy transitions. Thirdly, the relationship between the heterogeneity of governance and macroeconomic variables has not been explored extensively in the literature. In the context of the above, the present study contributes to the literature by moving beyond aggregated measures of institutional quality and exploring the heterogeneous impacts of different dimensions of governance on economic growth. In addition, the study focuses on the economies in transition and includes variables related to sustainability, such as renewable energy.

In the recent literature, there has been a growing emphasis on the significance of the quality of institutions in bolstering the efficacy of macroeconomic policies and promoting sustained economic growth. In a comprehensive study on the case of Thailand, Pastpipatkul and Ko [8] empirically investigated the moderating effect of the quality of institutions on the interrelation between fiscal and monetary policies and economic growth, covering the period from 2003 to 2023. By employing state-of-the-art econometric techniques, such as BART and time-varying SUR models, the authors reveal the crucial role played by certain dimensions of governance, such as voice and accountability and control of corruption, in the macroeconomic process. The study indicates that not only do robust institutions amplify the impact of macroeconomic policies, such as interest rates and export growth, but they also neutralize the adverse impacts of variables like household debt and energy. In addition, the study reveals that the efficacy of monetary policies is heavily contingent upon the quality of institutions, although the same does not hold true for fiscal policies, whose impact is neutral in the absence of robust institutions.

At the firm level, the relationship between institutional quality and growth dynamics seems to be more complex and nonlinear. In their recent research on the impact of institutional quality on sustainable firm growth in the context of North African countries, Abozeid et al. [29] used a system Generalized Method of Moments (GMM) estimator to analyze the effect of institutional quality on firm growth using panel data from non-financial firms in Egypt, Morocco, and Tunisia. The results of the study indicate the existence of a nonlinear relationship between institutional quality and firm growth, which can be described as a U-shaped curve. In other words, the authors show that institutional environments with low or very high institutional quality can be detrimental to firm growth. On the contrary, the study finds that the optimal institutional quality is beneficial to firm growth as it creates transparency and reduces uncertainty, which can promote sustainable firm growth.

The interrelation between the quality of institutions and the development of the financial sector has been seen to be a very crucial factor for the attainment of sustainable economic growth, especially for emerging economies. In their study on the South Asian economies, Ahmed et al. [6] examined the long-run interrelation between the quality of institutions, the development of the financial sector, and green growth for the period from 2000 to 2018. The authors, by applying panel cointegration tests like the Pedroni, Kao, and Westerlund tests, along with the estimation of the FMOLS and DOLS methods, confirmed the strong interrelation among the variables. The findings of the study confirmed the crucial role played by the quality of institutions and the development of the financial sector in the attainment of economic growth, especially the sustainable type. The study further confirmed the crucial role played by the quality of institutions in the attainment of the efficiency of the financial sector, thus promoting the attainment of green growth.

Moreover, the evidence from the advanced and emerging economies supports the long-run significance of the quality of governance in determining the economic growth path. In a recent study, Küçükçolak et al. [30] investigated the impact of the quality of governance on economic growth in G7 and E7 economies during the period from 2002 to 2023. Applying advanced panel econometric methods, namely VECM, AMG, and CCEMG estimators, the study finds the existence of a long-run stable relationship between the quality of governance and economic growth in the G7 and E7 economies. However, the rate of adjustment towards the long-run equilibrium is much faster in the G7 economies than in the E7 economies. Among the dimensions of the quality of governance, the rule of law and regulatory quality play a crucial role in determining the economic growth path. In contrast, the lack of accountability acts as a barrier to economic growth, especially in the emerging markets. The empirical evidence from the transition economies clearly underscores the significance of governance quality as a major factor for economic growth. Bayar [4] explored the role of six indicators of governance, using a panel study design, with a specific focus on the transition economies from the European Union. The empirical analysis is conducted over the period 2002–2013. The results clearly reveal that all aspects of governance, except for regulatory quality, have a statistically significant positive influence on economic growth. Moreover, control of corruption and rule of law emerge as the most significant factors, suggesting that institutional mechanisms to curb rent-seeking behaviour and provide a rule of law, respectively, play a vital role in economic growth. On the other hand, political stability, though positive, is found to have a relatively weaker influence. The empirical analysis thus underscores the heterogeneous role of governance indicators, which can provide more precise findings regarding the governance and growth linkages, particularly for transition economies, which face structural and institutional change. The role of institutional quality in resource-rich economies also adds further layers of complexity, especially in relation to economic diversification beyond resource-based sectors. In their research on the case of Azerbaijan, Seyfullayev and Cak [31] investigated the role of institutional quality on economic growth in non-oil sectors using an ARDL bounds testing model over the period 1996 to 2022. The results show that regulatory quality has a strong and significant impact on economic growth in non-oil sectors in both short and long run horizons, underscoring the need for effective regulatory environments to foster economic diversification in resource-dependent economies. However, government effectiveness does not show a statistically significant relationship with economic growth, underscoring that not all dimensions of institutional quality may equally contribute to economic performance. The relationship between institutional quality and economic growth is particularly evident in countries in the process of structural transformations and integration. Such countries include those involved in the European Neighbourhood Policy (ENP). Bartlett et al. [32] focused on assessing the role of institutional reforms and convergence towards European Union norms on economic growth in ENP countries. The study revealed that institutional reforms have a positive effect on economic growth, but the level of convergence towards European Union norms is lower compared to candidate countries. Of particular interest is the study’s revelation on the need to focus on critical aspects of governance in achieving economic growth. Political stability, government accountability, media freedom, and control of corruption are critical aspects of institutional quality that need attention in implementing economic policies. However, the study revealed an interesting aspect on the need to understand that institutional reforms alone cannot achieve the intended results. For instance, institutional reforms need to be complemented by societal institutional changes. Situations where institutional changes occur faster than societal institutional changes may result in corruption and political instability.

Table 7. The correlation matrix

Due to the high correlations among the institutional variables, the analysis also employs a second specification, where a composite institutional index is used. This composite index is obtained by averaging the four institutional variables. This would address the issue of multicollinearity, as well as provide a robustness test of the overall effect of institutions on economic growth.

Table 8. Panel data estimation results for economic growth (OLS, FE, and RE models)

Table 8 presents a summary of the results obtained using the pooled OLS, RE, and FE models. The presentation of the results obtained using the three models has a two-fold purpose: first, it provides a comparison of the results obtained using different models; second, it provides a test for the robustness of the results obtained for the institutions to the presence of omitted variables at the country level. However, the panel nature of the data set (10 transition economies over time) and the high variance components due to the country effects (ρ = 0.926 in the FE model) imply that the results obtained using the FE model will be used as the preferred specification. The results obtained using the FE model show that the aggregate effect of institutions on economic growth does not exist; rather, the effect of the control of corruption on economic growth is positive and statistically significant, implying that the growth dividends obtained in the transition economies as a result of the strengthening of anti-corruption policies are sizable.

In addition, the large and statistically significant coefficient for regulatory quality suggests the importance of the role played by structural policies to improve the efficiency and clarity of markets in the growth patterns. Government effectiveness does not have statistical significance in the within-country model and thus seems to play little role in stimulating growth in the absence of other structural policies. The macroeconomic stability has strong results in all the different model specifications. Inflation has a significant negative impact on growth, thus stressing the importance of price stability in the growth process in transition economies. Trade openness appears as a positive relationship in the FE model, suggesting that integration into the global economy could play a significant role in the growth process, controlling for country-specific structural factors. One of the more interesting results was the positive and statistically significant effect of renewable energy growth on economic growth in the FE model. While the RE model did not reject the statistical test of the FE model, the significant variations between countries indicated by the data, as well as the nature of the institutional variables, support the use of the FE model as the more credible approach to identifying the relevant variables. The results of the analysis tend to support the conclusion that economic growth in transition economies is driven by factors of governance, macroeconomic discipline, and changes in the structure of renewable energy systems, as opposed to averages of institutional factors.

The empirical results confirm that there is heterogeneity among institutional measures in relation to the association with economic growth and that the relationship depends on the specification used. The results from the random-effects regression, chosen as the base (based on the Hausman test, p = 0.157), indicate that a significant positive relationship exists between regulatory quality and economic growth, hence confirming that better regulation is associated with improved economic performance. The relationship between corruption and economic growth, however, is negative and statistically significant, meaning that poorer control of corruption leads to low growth rates. Rule of law and government effectiveness fail to demonstrate a statistically significant impact on economic growth in the models estimated. Of all the macroeconomic variables, the most significant and negative variable in each of the regressions was inflation. The effect of FDI is positive but marginally insignificant, while trade openness and GCF lack a significant impact. First, it is crucial to note that the coefficient for renewable energy consumption shows an unstable behavior. While the value is either negative or weakly significant in pooled and random-effects regressions, in the FE regression, the coefficient becomes significantly positive. Therefore, it can be noted that there is a difference between estimating the relationship using between-country (RE) and within-country (FE) variability; thus, the results should be considered carefully. When comparing the results of the FE and random-effects models, it can also be noted that estimates of parameters depend on model specification. Particularly, while there is almost no correlation between unobservable variables in the RE-model (as ρ is equal to zero), in the case of FE-approach, the degree of correlation between unobservable reaches approximately 0.93. Because of this, FE-estimation is considered as a robustness test. In general, the study confirms the hypothesis that the quality of institutions contributes to growth in the transition economies, yet their significance is not consistent and varies depending on particular dimensions and assumptions used in modeling. Because of possible multicollinearity and endogeneity, the conclusions can only imply associations rather than establish causality in the relationship studied.

In addition to these tests, a dynamic panel data regression using the two-step system GMM approach was performed (see Figure A2). The findings imply that the lagged dependent variable is not statistically significant (β = 0.066, p = 0.832) indicating no significant persistence in the dynamics of economic development. FDI appears marginally statistically significant (β = 0.434, p = 0.062) among other explanatory variables; all others are statistically insignificant.

Concerning model diagnostics, the Arellano-Bond test proves the existence of first-order serial correlation (AR(1), p = 0.049) and excludes the presence of second-order correlation (AR (2), p = 0.351). Nevertheless, the Hansen overidentifying restrictions test gives the value of the p-value equal to 1.000 which indicates a possible inadequacy of instruments. Taking into account the relatively small number of observations in the cross-sectional direction, such a finding indicates that estimates obtained by the method of GMM can be regarded with suspicion. Consequently, the FE estimation is regarded as more trustworthy and becomes the preferred specification. Further, four different model specifications were employed in Table 9. The first two were OLS pooling and FE regressions, respectively. The third one is the RE regression, and the fourth model used is the correlated random-effects/Mundlak estimator.

Table 9 provides the results of estimation using pooled OLS, FE, RE, and Mundlak models of GDP growth. All models use time FE; standard errors are provided in parentheses.

As shown in the results, inflation is negatively and significantly related to economic growth in all models, implying that an increase in the inflation rate leads to slower economic growth. In this case, the effect is the most pronounced in the FE and Mundlak models, showing the importance of within-country variation.

Among the institutional indicators used, we observe significant instability in model specifications. As we can see, some coefficients become insignificant and/or change their signs depending on the estimator used, while regulatory quality appears to be positively and significantly related to GDP growth in all models except the Mundlak one, implying some stability in the relationship. At the same time, we can observe that the effects of law, corruption control, and governance are sensitive to model specifications, implying potential multicollinearity between them. FDI has a positive effect, although it is significant only in FE and Mundlak models, while trade openness is insignificant in models without FE terms but becomes significant in FE and Mundlak models.

Table 9. Panel data estimates of economic growth (OLS, FE, RE, and Mundlak models)

The next important point is the estimate of renewable energy (energyren). The sign of its estimate changes according to the specification used and its coefficient is very sensitive to the choice of the model used. In the pooled OLS and RE models, it takes a negative value. However, when FE or Mundlak regression is used, the coefficient becomes positive and significant. Further, when the within-between model is considered, it is seen that while the within coefficient takes a positive and significant value, the between coefficient (estimated using mean values) takes a negative and significant value. This implies that an increase in renewable energy leads to growth within the country whereas an increase in renewable energy between countries results in low growth rates.

Further information can be gleaned from the Mundlak model (column 4) which allows us to separately assess the time-variant effect and the time-invariant country mean effect. As we see below, there are distinct differences in these two dimensions. Inflation continues to have negative and significant effect in the within-dimension case (β = −0.225, p < 0.01). Thus, an increase in domestic inflation is linked to a decrease in the rate of growth. Nevertheless, the cross-country variation of the mean effect (that is, the difference in the mean values) is insignificant (β = −0.006). As far as institutional indicators go, in most cases, they tend to demonstrate instability in the time-variant dimension, whereas the country mean effects are highly significant. In particular, the mean values of laws (β = 15.95, p < 0.01), control of corruption (β = −9.36, p < 0.01), and governance effect (β = −7.37, p < 0.01) show great significance. Therefore, in this case, long-term country-specific effects of institutional indicators play an important role in the formation of GDP per capita growth rates.

It should be noted that the Mundlak model (Column 4) gives some additional information as it separately estimates within and between effects of variables. The significance of group means for most institutional variables, FDI, and renewable energy clearly indicates that the assumption made in the random effect model about independence of variables from the error term does not hold. FDI display a positive and non-significant within-country effect (β = 0.344) and a strongly significant between-country effect (β = 0.697, p < 0.01), implying that an increase in the average level of FDI for countries leads to higher growth rates.

On the other hand, trade openness displays a positive and significantly influential within-country effect (β = 0.106, p < 0.05) while its effect on growth is negative and significant at the between-country level (β = −0.192, p < 0.01). As such, higher trade openness within a country is associated with higher growth rates, and thus higher trade openness may be detrimental to growth for some countries due to structural issues. A critical finding comes from the examination of renewable energy, which displays a positive and highly significant within-country effect (β = 0.503, p < 0.01), implying that higher renewable energy consumption is positively related to growth rate for countries. However, the between-country effect of renewable energy is negative and significant (β = −0.700, p < 0.01).

Consequently, it can be concluded that there is some violation of the assumption of the independent RE model where the unobservable variable and regressors are not correlated. This conclusion justifies the application of the correlated random-effects model (also known as Mundlak model) to address this issue. The findings indicate that the estimates are sensitive to the econometric framework, particularly for the institutional and environmental factors. The agreement between FE and the within component of the Mundlak approach implies that within-country variation offers better information content compared to cross-country comparison. VIFs were obtained to detect the possibility of multicollinearity among the predictors. According to the output, there is an indication of high to moderately high multicollinearity among the institutional indicators where the VIF for rule of law is 9.54, corruption control is 8.80, and regulatory quality is 8.19, thus explaining the theoretical similarity of these indicators. In addition, low VIF levels among variables like inflation, FDI, trade, and renewable energy indicate no multicollinearity issues. In regard to the high level of VIFs among time dummies, this is not surprising and does not create any methodology problem. Overall, it can be noted that this information confirms the observation that the coefficient variability of institutions can be attributed to multicollinearity problems.

The primary aim of the present study was to empirically investigate the impact of institutional quality, macroeconomic stability, and structural variables on the growth of economies undergoing the process of transition, with a special emphasis on the heterogeneous impact of disaggregated governance indicators. To achieve the above research aim, the present study employed panel data analysis techniques on a set of countries over the years, with the analysis incorporating individual dimensions of governance such as the rule of law, control of corruption, government effectiveness, regulatory quality, as well as relevant macroeconomic variables such as inflation, FDI, trade openness, GCF, and renewable energy. The results demonstrate that the impact of institutional quality on economic growth is not linear. Rather, the dimensions of good governance have heterogeneous impacts on economic growth. In the context of the study, the control of corruption is identified as a positive and statistically significant determinant of economic growth after controlling for unobserved country-specific effects, thus emphasizing the significance of the integrity of institutions. On the contrary, the use of the aggregated institutional index does not produce statistically significant findings, thus indicating that the overall index may hide the individual impacts of the different dimensions of good governance. Among the macroeconomic variables, inflation consistently displays a negative and statistically significant effect, thereby underlining the significance of macroeconomic stability. The variable "Renewable Energy" was found to be insignificant or, in some cases, negative. However, as expected, this variable was found to be positive and statistically significant in the FE model, thereby underlining the significance of this variable as a driver of sustainable economic growth. The variable "FDI" was found to have a positive but relatively weak effect, while other variables, such as "trade openness" and "Gross Capital Formation," failed to achieve significance. Thus, the results emphasize the significance of institutional quality as well as the macroeconomic environment to the growth process, although the results show the complexities involved. The study adds to the existing literature as it shows the significance of using disaggregated governance indicators compared to aggregate ones, as well as the significance of methodology when working with panel data analysis. The results have significant policy implications as they emphasize the significance of institutional reform efforts, especially in the context of fighting corruption and improving the regulatory environment, as well as the maintenance of a healthy macroeconomic environment and the support of renewable energy sources, to the growth process of transition economies.

The empirical results of the present study have several implications for policymakers in the context of the economies in transition that aim to secure sustained economic growth. Firstly, the results emphasize the significance of the positive impact of institutional quality improvements, especially with regards to the reduction of corruption, on the enhancement of the economic performance of the economies. On the other hand, the positive contribution of regulatory quality to the economies suggests the significance of the regulatory frameworks to the economies. The positive impact of regulatory quality suggests the significance of the regulatory frameworks to the economies. Policies aiming to simplify the regulatory environment, to overcome inefficiencies in the bureaucratic process, etc., can be beneficial to the economies. The continued negative impact of inflation underscores the significance of macroeconomic stability. Guaranteeing low inflation through the implementation of monetary and fiscal policies remains one of the fundamental prerequisites for sustaining economic development while promoting domestic and foreign investment. The results also underscore the emerging significance of renewable energy as a factor in promoting sustainable economic development. Supporting the development of renewable energy through targeted investments, financial support, and policy frameworks. In addition, it is evident from the results that institutional effects are not homogeneous, as indicated by the fact that the aggregated institutional index did not produce any significant results. This shows that policy interventions should not be based on generalized institutional reforms but rather target specific aspects of governance that are more important in terms of their contribution to economic outcomes. Generally, it is evident from the study that a combination of institutional reforms, macroeconomic stability, and support for structural transformation, especially in the energy sector, is critical in promoting long-term and sustainable economic growth in transition economies.