Abstract
<title>Abstract</title> <p>Does institutional quality lower the price a country’s private sector pays for credit, or does the cross-country correlation between governance and finance simply reflect that richer, more financially developed countries also tend to be better governed? We assemble an annual panel of up to 206 countries, 1996–2023, combining the World Bank’s interest-rate risk spread with the Worldwide Governance Indicators as a composite state-capacity index, and apply four strategies: two-way fixed-effects panel regressions, an instrumental-variables design using each country’s earliest capacity reading, a between-country estimator tracing mediation through financial depth and income, and dynamic panel GMM estimators. The within-country estimate is negative and marginally significant: a one-standard-deviation increase in capacity is associated with a lending spread 2.0 to 2.6 percentage points lower, surviving instrumentation with capacity’s initial-period value. Disaggregating the index shows rule of law, regulatory quality, and politicalstability carry the relationship more than corruption control or government effectiveness. The long-run association, however, is substantially mediated by private-credit depth and income per capita: once fixed, capacity’s direct effect on the spread is statistically indistinguishable from zero, suggesting capacity operates on the cost of credit largely through deepening financial markets and raising income rather than as an independent price signal. A randomization placebo returns a null effect, a one-year lag of capacity preserves the result, and dynamic GMM estimators are reported but not relied upon given diagnostic failures. The evidence supports a real but partly mediated channel from institutional quality to the cost of private credit. JEL Classification: G15; O43; E43; F34; H11.</p>