The impact of corruption on the black market premium.

Author:Bahmani-Oskooee, Mohsen

1. Introduction

One of the features of most countries, especially developing nations, is corruption that exists in the private as well as the public sector. There are different factors that make one country more corrupt than others. These may include the level of education, the degree to which political rights are granted, per capita income, the degree of competition, pay rate in civil service, and so on (Ades and Di Tella 1999; van Rijckeghem and Weder 2001). The impact of corruption on different sectors of an economy or on different macro variables is a relatively new area of research in economics that has been getting attention in recent years. (1)

The impact of corruption on inflation is investigated by Cukierman, Edwards, and Tabellini (1992), who argue that countries with more corruption have inefficient tax systems, inducing governments to resort to inflationary tax policies. Therefore, they conclude that countries with more corruption are subject to high inflation rates. Al-Marhubi (2000) provides an empirical counterpart by analyzing the relationship between inflation and corruption using cross-sectional data from 41 countries and finds a significantly positive relationship.

Mauro (1995) examines the relation between corruption and investment as well as the relation between corruption and economic growth using cross-sectional data. He finds a significantly negative relation between corruption and both investment and economic growth. Ehrlich and Lui (1999) arrive at a similar conclusion and argue that such a negative relation is explained as an endogenous outcome of competition between growth-enhancing and socially unproductive investments. Bardhan (1997, p. 1322) argues that corruption can hurt economic growth if it takes the form of bribery and that the briber can get away with supplying a low-quality good at a high-quality price.

The impact of corruption on public investment, government revenue, quality of infrastructure, and quality of roads is the subject of an empirical study by Tanzi and Davoodi (1997). They find that corruption lowers economic growth through three channels: first, by reducing the productivity of public investment; second, by reducing the standard of infrastructure facility; and, finally, by reducing government expenditure. Two other studies have looked at the impact of corruption on the size of government budget relative to gross domestic product (GDP). LaPalombara (1994) shows that the higher the degree of corruption, the higher the size of government budget relative to GDP. Such positive association is contradicted by Elliot (1997), who employs cross-sectional data from a larger sample of 83 countries.

Gupta, Davoodi, and Alonso-Terme (1998) argue that the benefits from corruption are likely to go to wealthy people at the expense of the poor. Thus, corruption results in a higher degree of income inequality. By employing data from 37 countries, they show that there is a significantly positive relation between corruption and the Gini coefficient. Of course, this was the finding after taking into account the other exogenous variables in the model, such as real per capita income growth, natural resource endowment, years of secondary education, initial distribution of assets, and social spending (various measures relative to GDP).

Finally, Bahmani-Oskooee and Nasir (2002) argue that since countries with more corruption do have higher inflation rates and are less productive, following the "productivity bias hypothesis," they should experience a real depreciation in their currency. They test this hypothesis by using three different measures of corruption from 65 countries in a cross-sectional as well as panel setting. Their ordinary least squares (OLS) as well as generalized least squares results reveal strong empirical support for their conjecture that countries with more corruption do experience real depreciations in their currencies. However, they alert the reader to the fact that such a finding should not encourage countries to become more corrupt so that they can gain international competitiveness. Indeed, forces (increased corruption) that are making a country competitive on one hand are the same forces that are making the same country less productive, less efficient, and more prone to inflation on the other. These later impacts on domestic economy, they argue, could have grave long-run consequences that could more than offset any gain in international competitiveness.

In this article we expand the empirical literature on corruption by investigating its impact on the black market premium. As the previously mentioned review reveals, no study has made an attempt to investigate the impact of corruption on the black market premium. To this end, in section 2 we provide our theoretical arguments for the relation between corruption and the black market premium along with a model that is to be estimated. In section 3 we present our empirical findings that support the notion that countries with more corruption do have higher black market premiums. Section 4 concludes.

2. Theoretical Arguments and a Model

In many developing countries, because of excess demand for foreign currencies, governments impose controls on trade and capital flows to suppress the demand. Usually, when controls are imposed, central banks also set the exchange rate at an officially fixed level and require all market participants to trade at those fixed rates. Furthermore, they introduce guidelines for allocating their limited amount of foreign exchange. Thus, those in need of foreign exchange whose demands are not satisfied have no choice but to engage in the black (illegal) or parallel (legal) market activity, though at a rate much higher than the official exchange rate set by the government. The percent difference between the black market rate and the official rate constitutes the black market premium. What macro factors determine the premium?

Since the official exchange rate is fixed, factors that determine the premium must also be the factors that determine the black market exchange rate itself. While some factors affect the demand side of the black market, some others affect the supply side of the market. On the supply side, a few studies, such as Sheikh (1976), Martin and Panagariya (1984), and McDermott (1989), have emphasized the role of smuggling, underinvoicing of exports, and resale of officially allocated foreign exchange as the main sources of supply. On the demand side, de Macedo (1987) argues that in some countries the tariff rate on importation of some commodities is so high that it pays to smuggle the goods and finance them through the black market. Thus, a high tariff rate is identified as a major factor for increased demand for foreign exchange in the black market. On the other hand, the portfolio-balance approach developed by Dornbusch et al. (1983) identifies portfolio diversification as a major component of the demand for foreign exchange in the black market. In such models, Agenor (1992, p. 15) argues that loss of confidence in domestic currency, fears of inflation, increasing taxation, and low real domestic interest rates all contribute to an increased demand for foreign currency.

Our conjecture in this article is that since corruption does affect either the demand or the supply of foreign exchange in the black market, it could be another determinant of the black market premium. The extent of the impact...

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