Corruption warps policy and lets the well-connected take advantage of the system. It stifles innovation and lowers economic growth. It erodes trust and leads to a crisis of confidence. It also makes it harder to invest in the economy and raises the risk of a stock market crash.
BRIC countries have exhibited enviable economic growth, but they score poorly on Transparency International’s Corruption Perceptions Index. Corruption can be a big obstacle to attracting foreign investment and growing the economies. In fact, it can even cause a stock market crash as investors flee countries that are perceived to be corrupt.
A recent example is the stock market collapse of Italian defence company Finmeccanica after its CEO was arrested for bribing Indian officials to sell helicopters. This is just one of a number of high-profile corruption scandals in the defense sector. The UK arms manufacturer BAE recently pleaded guilty to bribing Saudi officials for fighter planes and paid a record fine of £780 million.
Using a panel two-way fixed effect model with monthly data, we estimate the interaction effects of corruption and institutional factors on stock returns. We find that the individual coefficient of corruption has a negative effect on stocks, but this becomes less pronounced with the maturation of democracy within the country. The interaction of bureaucratic quality and corruption, on the other hand, has a mixed effect: while enhancing the quality of bureaucracy mitigates the bad effects of corruption and boosts stock returns, corruption itself distorts law and order and lowers stocks.
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