The governments of BRIC countries are important contributors to global business and investment. However, they have imperfect institutions. Corruption and its consequences are a significant threat to investors. The demand for special payments and bribes can be encountered with respect to a wide variety of issues such as import and export licenses, exchange controls, tax assessments, police protection or loans. Such corruption increases transaction costs, reduces efficiency and erodes profits for firms. This can also negatively impact stock markets.
A well-known example is the corruption scandal in defence contractor Finmeccanica involving bribing Indian officials to obtain contracts for helicopters worth EUR560 million. This scandal severely impacted the company’s reputation and lowered stock prices. However, little research has been done on the stock market dimensions of corruption.
In this paper we analyze the effect of corruption and its interaction with institutions on stock market returns using a panel two-way fixed-effect model at monthly frequency for the BRIC countries. We estimate coefficients for corruption, democratic accountability (DA), bureaucratic quality (BQ) and law and order (LO) as free variables. The coefficients show that the impact of corruption is negative and is significantly influenced by institutional components such as DA, LO and BQ. This support the ‘sand in the wheel’ hypothesis of corruption and institutions.
Moreover, we show that the impact of corruption on stock market returns is more intense when the country is less democratic and the interaction with institutions is stronger. Corruption exacerbates the adverse effects of democracy on stock market growth by distorting the rule of law and decreasing investment efficiency.
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