The effects of corruption on FDI inflows.

Author:Al-Sadig, Ali

The surge in foreign direct investment (FDI) flows during the 1990s has motivated a host of recent studies into their determinants. Recently, the level of corruption in the host country has been introduced as one factor among the determinants of FDI location. From a theoretical viewpoint, corruption that is, paying bribes to corrupt government bureaucrats to get "favors" such as permits, investment licenses, tax assessments, and police protection--is generally viewed as an additional cost of doing business or a tax on profits. As a result, corruption can be expected to decrease the expected profitability of investment projects. Investors will therefore take the level of corruption in a host country into account in making decisions to invest abroad.

The empirical literature on the effects of the host country's corruption level on FDI inflows, however, has not found the commonly expected effects. Some empirical studies provide evidence of a negative link between corruption and FDI inflows, while others fail to find any significant relationship.

Most existing studies use a cross-sectional rather than a panel data analysis to examine the effects of a complex phenomenon. Such a method cannot control for the unobserved country-specific effects that may vary across countries and may be correlated with corruption. Even if a panel data analysis is implemented, those studies have ignored the fact that corruption is not necessarily an independent variable. It is a consequence of economic and noneconomic variables and so must be treated as an endogenous variable.

Motivated by these issues, the main objective of this article is to empirically reexamine the effects of corruption on FDI inflows by incorporating an econometric method based on panel data from 117 host countries over the period 1984-2004. More precisely, this article intends to answer the following question: Does a corrupt host country receive less or more FDI inflows after controlling for other determinants of FDI location?

Our results show that the corruption level in the host country has an adverse effect on FDI inflows: a one-point increase in the corruption level leads to a reduction in per capita FDI inflows by about 11 percent. However, after controlling for other characteristics of the host country such as the quality of institutions, the negative effects of corruption disappear and sometimes it becomes positive but statistically insignificant.

In fact, the results show that the country's quality of institutions is more important than the level of corruption in encouraging FDI inflows into the country. For instance, ceteris paribus, a country with sound institutions is able to attract as much as 29 percent more per capita FDI inflows than a country with poor institutions.

FDI Inflows and Corruption

Due to the various forms that corruption can take, including practices such as bribery, extortion, influence, fraud, and embezzlement, corruption has been defined in different ways. Yet, since we are concerned only with corruption that affects the costs of investment operations, we use Macrae's (1982: 679) definition. He defines corruption as an "arrangement" that involves "a private exchange between two parties (the 'demander' and the 'supplier'), which (1) has an influence on the allocation of resources either immediately or in the future, and (2) involves the use or abuse of public or collective responsibility for private ends." The demanders in our case may be the public officials and the suppliers are foreign investors.

The debate on the adverse effects of the level of corruption on FDI inflows has been analyzed in context of the costs of doing business. Since foreign investors have to pay extra costs in the form of bribes in order to get licenses or government permits to conduct investment, corruption raises the costs of investment. Such additional costs decrease the expected profitability of investment and so corruption is generally viewed as a tax on profits (Bardhan 1997). Moreover, corruption increases uncertainty because corruption agreements are not enforceable in the courts of law.

It has been shown that corruption has adverse effects on economic performance. (1) Corruption has a negative impact on the level of investment and economic growth (Mauro 1995), on the quality of infrastructure and on the productivity of public investment (Tanzi and Davoodi 1997), on health care and education services (Gupta, Davoodi, and Tiongson 2000), and on income inequality (Gupta, Davoodi, and Alonso-Terme 1998; Li, Xu, and Zou 2000). All those factors are found to be important determinants of FDI location. Therefore, foreign investors would tend to avoid investing in countries with high levels of corruption.

However, there may exist positive effects of corruption on FDI inflows. In the presence of a rigid regulation and an inefficient bureaucracy, corruption may increase bureaucratic efficiency by speeding up the process of decisionmaking (Bardhan 1997). However, this view has been rejected empirically. Kaufman and Wei (1999) using firm level data covering more than 2,000 firms find that firms paying more bribes spend more time negotiating with bureaucrats. But two recent studies show that the effects of corruption depend on the country's rule of law and economic freedom. Houston (2007), studying the effects of corruption on a country's economic performance, finds that corruption has positive effects on economic growth in countries with a weak rule of law, while it has negative effects in countries with sound institutions. Also, Swaleheen and Stansel (2007) find that corruption enhances economic growth in countries with high economic freedom, while it hinders economic growth in countries with low economic freedom.

Previous Empirical Studies

The empirical literature on the relationship between corruption and FDI has not reached the commonly expected conclusion that a perceived high level of corruption in the host country deters FDI. In a study of foreign investment by U.S. firms, Wheeler and Mody (1992: 70) did not find a significant relationship between the size of FDI and the host country's risk factor, and they concluded that the importance of the risk factor should "be discounted, although it would not be impossible to assign it some small weight as a decision factor." Wei (2000a), however, argues that the reason why Wheeler and Mody (1992) failed to find a significant relationship between corruption and FDI is that corruption is not explicitly incorporated into their model. They combined corruption with 12 other indicators to form one variable, but some of these indicators may be marginally important for FDI.

Hines (1995) examines the effect of the U.S. anti-bribery legislation (Foreign Corrupt Practices Act of 1977) on the operation of U.S. firms in countries where corruption is high. He uses the growth rate of U.S. FDI flows into 35 host countries over the period 1977 to 1982 as the dependent variable and the Business International Index as a measure of corruption. His finding suggests that the Corrupt Practices Act significantly reduced U.S. FDI flows into more corrupt host countries 'after 1977. (2)

Abed and Davoodi (2000) use a cross-sectional as well as a panel data analysis to examine the effects of levels of corruption on per capita FDI inflows to transition economies. They find that countries with a low level of corruption attract more per capita FDI. However, once they control for the structural reform factor, corruption becomes insignificant. They conclude that structural reform is more important than reducing the level of corruption in attracting FDI.

Wei (2000a: 1) examines the effects of taxation and corruption on FDI using bilateral FDI flow data from 12 source countries to 45 host countries. Using three different measures of corruption, he concluded that an increase in either the tax rate on multinational firms or the level of corruption in the host countries would reduce inward FDI. "An increase in the level of corruption from that of Singapore to that of Mexico would have the same negative effect on inward FDI as raising the tax rate by 50 percentage points." By again using survey data on countries' investment environments, Wei (2000b) also examines corruption's effects on the composition of capital flows using bilateral capital flow data from 14 source countries to 53 host countries. His findings suggest that there is indeed a negative relationship between corruption and FDI and that the reduction in FDI caused by corruption is greater than the negative impact of corruption on other types of capital inflows. (3)

Focusing on only developing countries, Akcay (2001) uses cross-sectional data from 52 developing countries with two different indices of corruption to estimate the effects of the level of corruption on FDI inflows. He fails to find evidence of a negative relationship between FDI and corruption. He concludes that the most significant determinants of FDI are market size, corporate tax rates, labor costs, and openness.

Smarzynska and Wei (2002) use a firm-level data set from transition economies to investigate the effects of corruption in terms of firms' decision not to enter a particular market, rather than in terms of reduced bilateral investment flows. Conditional on FDI taking place, their results show that FDI entry strategy in a corrupt host country is to enter into joint ventures with a domestic partner to save the transaction costs of dealing with local government officials rather than to establish a wholly owned subsidiary.

Habib and Zurawicki (2002) analyze the effects of corruption on bilateral FDI flows using a sample of seven source countries and 89 host countries. They hypothesize that the greater the absolute difference in the corruption level between the source and the host countries, the smaller the FDI inflows for the host country. They regressed bilateral FDI on a set of control variables including...

To continue reading