The Empirical Economics Letters, 9(9): (September 2010) ISSN 1681 8997

Effects of Decentralization on Macroeconomic Instability:

Importance of Political and Institutional Factors
Ahmad Zafarullah Abdul Jalil
Department of Public and Monetary Economics
Field of Social Science, College of Arts and Sciences
Universiti Utara Malaysia
Email: zafar@uum.edu.my
Abstract: This paper examines the relationship between decentralization and
macroeconomic stability. Even though there is a huge literature on the impact of
decentralization, only a few of them seems to be interested on the link between
decentralization and macroeconomic instability. It is thus our hope to shed more lights
on the issue by looking at other dimensions of macroeconomic stability and by
examining factors that might accentuate or diminish the effects of decentralization on
macroeconomic instability. Evidence provided in this paper points to the fact that there
is a negative relationship between macroeconomic stability and decentralization.
Keywords: Decentralization, Macroeconomic Stability, Fiscal Federalism,
Institutional and Political Environment
JEL Classification Number: H5, H6, H7
1. Introduction
The main objective of this paper is to fill a critical gap in the literature by analyzing the
effects of decentralization on the macroeconomic stability. A survey of the voluminous
literature on decentralization suggests that the question of the links between
decentralization and macroeconomic has been relatively scantily analyzed. Even though
there is still a lot of room for analysis as far as the effects of decentralization on other
aspects of the economy are concerned, we believe that it is in this area that a more thorough
analysis are mostly called for. Through this paper, we will try to shed more lights on the
issue notably by looking at other dimension of macroeconomic stability than the ones
usually employed in previous studies as well as by examining other factors that might
accentuate or diminish the effects of decentralization on macroeconomic stability2.
The paper starts by reviewing the literature on the effects of decentralization on
macroeconomic instability. Section 2 presents our econometric approach as well as our
results. Finally section 3 concludes.

2. Literature Review
It is noteworthy that there is a slight tendency to associate decentralization with less
macroeconomic stability owing notably to the fact that decentralization is usually
The Empirical Economics Letters, 9(9): (September 2010) 850

accompanied by an increase of autonomy level of the local governments. Ahmad et al

(2005) held that macroeconomic stability for a country or supranational economic union
depends on the overall aggregate exposure to risk. Decentralization means that local
governments will be granted more power in determining the level of their expenses as well
as their revenues. This in turn means that central government will have less power to
control the behavior of the subnational governments. On the other hand, under the logic of
commitment problem, decentralization is associated with more price and macro stability.
Fiscal decentralization may make it more difficult for policymakers to renege on their
commitment for price stability. The competition among lower levels of governments may
reduce their incentives to renege on stable monetary policy (Qian and Rolland 1998). On
the empirical grounds, there have been very few studies that analyze the effects of
decentralization on macroeconomic stability and almost all of them used the inflation rate
as their indicator for macroeconomic instability. King and Ma (2001) examined the effects
of centralization on inflation using data that covered 42 countries over the period of 1973-
1994. However, they only found a significant positive correlation between centralization
and inflation when they omitted from their sample “high-inflation” countries defined here
as those who have an average inflation of more than 20%. The paper was later
reinvestigated by Neyapti (2003) who argued that decentralization and central bank
independence reinforce each other in determining the inflation rate since decentralising
revenue collection by itself need not be efficient as local authorities have much more
limited tax bases available to them as well as limited capacity to issue debt. More recently,
Vazquez and McNab (2005) found that decentralization appears to promote price stability.
Their results are consistent both in the full and sub-sample of developed, developing and
transitional countries. This suggests according to the authors that their results are not
dependant on the level of development.

3. Econometric Estimation
The hypothesis that we want to test here is whether decentralization will lead to more or
less macroeconomic instability. Our data covers 62 countries from the period of 1972 to
2001. This data set is structured as a panel with observations for each country consisting of
five-year averages. Each country has six observations: 1972-1976, 1977-1981, 1982-1986,
1986-1991, 1992-1996, 1997-2001. The panel is, however, not balanced because some
observations are missing for a number of countries. Table 1 summarizes the descriptive
statistics of the variables.

Data related to decentralization are obtained from the Government Finance Statistics (GFS)
published by the International Monetary Fund. More precisely the following indicators will
be used as our measure of decentralization:
The Empirical Economics Letters, 9(9): (September 2010) 851

• the percentage of subnational governments expenditure of the total government

expenditures
• the percentage of subnational governments revenues of the total government
revenues.
In this study we will use change in the de facto market exchange rate (Reinhart and Rogoff
(2004) as a measure of macroeconomic instability.

Table 1: Descriptive Statistics

Obs. Mean Standard Min Max
Exchange rate 276 39.1493 181.3336 -45.4418 911.893
Exp. Decentralization 261 26.2867 17.0294 1.4547 75.7473
Rev. Decentralization 252 19.0472 15.3016 0.6279 76.4074
GDP 287 9927.86 9234.279 137.5408 41559.24
M2 210 61.5306 212.347 1.5304 1852.052
Population 312 6.55e+07 1.85e+08 164949.6 1.25e+09
Openness 287 68.1632 42.4824 8.6815 258.4703
C. Bank Independence 131 0.4680 0.1930 0.17 0.89
Corruption 186 6.0889 2.4440 0.2 9.8099
Democracy 265 5.3524 7.6298 -52.8 10
Executive Constraints 265 4.2709 6.6405 -52.4 7
Polity 265 3.5426 9.4227 -56.8 10
Political Rights 303 2.6712 2.0270 -1.8 7
Government size 277 57353.82 123153.3 0 862603.4

Using the data described above, we estimate the following model

MS it = β 1 FDit + β 2 Polit + δ ′Z it + u it (1)
Where MSit is the measure of macrostability represented here by the evolution of the de
facto exchange rate. FDit is the measure of fiscal decentralization, Polit denotes a measure
of political institutions which will be represented by four variables: the level of political
rights, the democracy level, the polity and the constraint on executive. The Zit matrix
comprises of several control regressor (M2 as a percentage of GDP, the index of central
bank independence, the per capita GDP, the total population, the government size, the
openness to international trade and the level of corruption). And finally uit is the error term.
We start by testing for the presence of endogeneity problem in our estimation. In the case
of our main independent variables, the results show that we fail to reject the exogeneity of
the fiscal decentralization with respect to all our dependant variables. We also fail to reject
The Empirical Economics Letters, 9(9): (September 2010) 852

the null hypothesis of exogeneity of several of our control variables namely the GDP per
capita, the M2 and the openness variable.
We then examine whether a fixed or a random effect model is more appropriate for the
estimation of equation 1. The results of the tests are in favor of a fixed effect specification.
4. Estimations Results
The results of our estimations are presented in table 2 and 3. In table 2, the level of
decentralization is represented by the proportion of subnational expenditure to total
expenditure where else in table 3, we use the proportion of subnational revenue to total
revenue as our measure of decentralization.
As shown by Table 2, we do not find any significant correlation between expenditure
decentralization and the change in de facto exchange rate. However there appears to be a
significant correlation between the change in exchange rate and the political variables. All
four variables representing the political and institutional setting are found to be negatively
correlated with the exchange rate. An increase in political rights, democracy or the
constraint on the executive leads to a more stable exchange rate. We also found the
corruption level to be positively correlated the change in the exchange rate which signifies
that an increase in the perceived level of corruption will lead to an increase in macro
instability.

Table 2: Expenditure Decentralization and the Evolution of De Facto Exchange

Rate
A B C D E F
Decentralization -4.38 -5.46 -4.54 -4.08 -4.01 -4.21
Central bank -320.12* -82.42 -153.54 -48.14 -68.25 -55.75
independence
GDP 425.03 -73.52 51.58 147.65 137.01 151.49
Openness 2.38 1.95 1.11 3.44 3.60) 3.81
Population -627.47*** -720.31 -871.94* -024.42*** -002.23*** -067.74***
Corruption 107.28** 94.41** 119.12*** 110.98** 120.53***
Political Rights -59.34*
Democracy -8.33**
Polity -6.49**
Executive -9.71***
Contraints
Constant 23666.11*** 12315.64*** 13998.29*** 32373.91*** 32120.06*** 33047.08***
R2 between 0.18 0.17 0.22 0.42 0.42 0.44
No of obs 276 276 276 276 276 276
No of countries 46 46 46 46 46 46
Notes: *, ** and *** indicate significancet at 10%, 5% and 1% levels respectively.
The Empirical Economics Letters, 9(9): (September 2010) 853

Table 3: Revenue Decentralization and the Evolution of De Facto Exchange Rate

A B C D E F
Decentralization -9.72 -25.78** -24.05** -20.76* -21.42* -20.69*
Central bank -315.31* -6.42 -73.51 37.66 23.71 29.37
independence
GDP 414.83 -189.30 -70.83 38.35 23.64 43.04
Openness 2.37 2.1032 1.33 2.94 3.05 3.29
Population -625.70*** -520.74 -662.17 -1731.66** -1695.55** -1777.59**
Corruption -118.91*** -107.03*** -126.81*** -119.53*** -127.96***
Political Rights -53.40
Democracy -7.94**
Polity -6.27*
Executive -9.26**
Contraints
Constant 23880.72*** 10259.94 11800.21 28697.24*** 28254.98*** 29405.74***
R2 between 0.19 0.24 0.28 0.47 0.47 0.48
No of obs 276 276 276 276 276 276
No of countries 46 46 46 46 46 46
Note: *, ** and *** indicate significancet at 10%, 5% and 1% levels respectively.

The results change when we use the share of subnational’ revenue as our measure of
decentralization. As reported in Table 3, the change in the exchange rate is found to be
negatively influenced by the revenue decentralization. Note that again the correlation only
become significant once we control for corruption and political variables (column B to F,
Table 3). As for the control variables, we found that all the political variables except for
one (the political rights) to be significantly correlated with the change in the exchange rate.
The results signify that a country that has a good governance track record will also have a
stable exchange rate.

5. Conclusion
This paper attempts to shed more lights on the relationship between decentralization and
macroeconomic stability. Even though there is a huge literature both theoretically and
empirically on the impact of decentralization, not many of them seems to be interested on
the question of the link between decentralization and macroeconomic stability. It is thus
our hope to fill this gap in the literature.
Based on our literature review, it is quite obvious to see that there are still lots to be done as
far as the links between decentralization and macroeconomic stability are concerned. It is
also noteworthy that so far, the studies that have been done in this area seemed to ignore
various other factors that could influence directly or indirectly the effects of
The Empirical Economics Letters, 9(9): (September 2010) 854

decentralization on macroeconomic stability. One type of variables that we believe to be

rather important is the ones that capture the existing institutional and political setting of the
country in question. These variables have been widely studied notably from the angle of
the impact that decentralization may have on them. However there are yet any studies that
try to examine the impact that these variables may have on the impact of decentralization
on macroeconomic stability. We have thus included in our study several indicators of
political institutions as well as a variable representing the corruption level.
The empirical results provided in this study despite data inadequacies and methodological
shortcoming point to the fact that there is a negative relationship between macroeconomic
stability and decentralization. In our baseline estimations, we found that decentralization
appears to lead to a decrease in the change of de facto exchange rate. Our results seem to
run counter to a rapidly growing popular belief that decentralization is disastrous to
macroeconomic stability. As far as our results are concerned, fiscal decentralization is
manifestly not a recipe for disaster.

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