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Javier Perez, EMI Research Director

Javier Perez, EMI Research Director

Mar 25 2014

Corruption, Part 2 - Excerpts from The Impact of Corruption on Financial Markets by David Ng

By Javier Perez, EMI Research Director

Corruption is a serious issue in many parts of the world.  Anecdotal evidence has shown the disruptive effect of corruption, and theoretical literature largely confirms this effect. Empirical studies show that the cost of corruption is highly significant in many different areas of the economy. In particular, across international financial markets, corruption is found to be associated with higher borrowing cost, lower stock valuation, and worse corporate governance. Corruption has [also] been shown to be associated with a wide variety of social and economic problems, including lower economic growth, foreign direct investment, infant mortality rate, and military spending[1].

What gives rise to corruption?  In a comprehensive study, Treisman (2000) examines the relation between corruption indices and a country’s historical, cultural, economic, and political characteristics. He finds that countries with lower corruption tend to be largely Protestant, former British colonies, have higher per capita income, a common law (vs civil law) legal system, a high ratio of imports to GDP, long exposure to democracy, and a unitary form of government. The direction of causality on economic development (per capita income) runs both ways. Treisman (2000) argues that these findings are broadly consistent with the theory on the expected costs and benefits of committing a corrupt act[3].

How is corruption measured? Because corruption is inherently subjective, the measure of corruption is often a problem. Most studies use perception-based measures of corruption. There are many polls that measure the level of corruption. These surveys are based on different criteria. Some are assessments by country risk analysts based in the home country or abroad. Some are surveys of local or expatriate businessmen. Others are surveys based on local residents. The three most popular surveys are from the Economist Intelligence Unit, International Country Risk Guide, and Transparency International’s Corruption Perception Index (CPI).

Although different surveys are collected by different methods, ratings from different polls show a high degree of correspondence with each other. Treisman (2000) points out that indices of corruption that come from surveys of businessmen conducting business in a country are highly correlated with the indices of corruption that come from surveys of the citizens in these countries. Also, using these surveys, researchers find that corruption is correlated with the variety of economic and social phenomena that we mention earlier.

Why does corruption affect business? The existence of corruption creates the wrong set of incentives in the society. As Ehrlich and Lui (1999) comment, ‘‘. . . since bureaucratic power holds the promise of economic rents through corruption, individuals have an incentive to compete over the privilege of becoming bureaucrats. Existing literature has referred to such activity as ‘‘rent seeking’’ (e.g. Krueger, 1974).

Corruption is sometimes considered to be similar to taxation. However, as pointed out by Shleifer and Vishny (1993), corruption and taxation are distinct because of the following points.  First, corruption is illegal, and it must therefore be kept secret. This creates many agency problems in the economy, [that] create waste and increase transaction costs in the economy.  Second, there is no limit to the number of bribes that a business might have to make in order to operate.

Empirical evidence on the adverse effect of corruption on financial markets.  Recent empirical studies have examined the effect of corruption on financial markets. A number of empirical studies examine the effects of corruption on financial markets. In particular, Ciocchini et al. (2003) looks at bond spread as a proxy for borrowing cost, while Fisman (1991) and Lee and Ng (2005) examine stock market valuation.

Borrowing costs: Ciocchini et al. (2003) show that corruption increase borrowing costs for governments and firms in emerging markets. This paper focuses specifically on the role of corruption in determining the price of emerging market bonds sold on the global bond market. Ciocchini et al. (2003) use the launch spreads of these bonds, which refer to the difference between the initial yield of these bonds and the rate commanded by a risk- free bond of the same maturity. The spread of these bonds reflects the higher default probability associated with emerging market debt. They are in effect studying the relationship between corruption and the perceived likelihood that a firm or government will default on its debt.

The main finding is that global investors require a substantially greater return on debt when the issuer is in a more corrupt country. This is true even after controlling for other factors that determine default risk. Their estimation includes macroeconomic variables, such as GDP growth and external debt, as well as a credit rating score from Institutional Investor that captures political risk. Corruption plays an important role in determining default risk even apart from its impact on other types of economic performance[9].  They estimate that a decrease in the level of corruption from that of countries such as Ukraine to that of Turkey or Lithuania is associated with about a 20 per cent decrease in spreads. 

Stock prices:  Corruption can affect equity value drivers like a firm’s long-term growth. Fisman (1991) examines the value of political connection in Indonesia by examining the stock prices of companies that have different degrees of political connections. He relates the news on the health of the former Indonesian President Suharto to the stock returns of these companies. He shows that bad news on Suharto’s health lead to reliably lower stock returns of the companies with extensive political connections than the independent companies.

Lee and Ng (2004) document the empirical relationship between the level of corruption within a country and the valuation of its corporations to shareholders. Specifically, they use firm-level data from 43 countries to evaluate the empirical relationship between corruption and international corporate values. They find that firms from more corrupt countries trade at significantly lower market multiples, after controlling for other factors.  They document that corruption significantly decreases equity values after controlling for many other firm- and country-level control factors.  Lee and Ng find that firms from more corrupt countries trade at significantly lower market multiples, after controlling for these factors. They conclude that corruption has significant economic consequences for shareholder value.

One potential reason why corruption may affect stock valuation has to do with corporate governance. To investigate this hypothesis, Ng and Qian (2004) examine the impact of corruption on corporate governance. They build a model demonstrating that an insider has more incentives to expropriate an outsider if bribery reduces the probability that the insider will get caught. As a result, corporate governance will be worse in more corrupted countries. They use firm-level corporate governance from two different surveys (i.e. those of Credit Lyonnais Securities Asia and Standard and Poor) and examine how country-level corruption data would affect corporate governance in different firms. The empirical analysis suggests that corruption has a significant impact on both corporate governance and a firm’s valuation.

Another reason why corruption may affect stock price has to do with the behavior of foreign investor.  Gelos and Wei (2005) show that lower country transparency is associated with lower investment from international funds. They also find that during financial crises, international funds flee non-transparent countries by a greater amount than their transparent counterparts. Given the link between secrecy and corruption mentioned earlier, it seems that corrupted countries will receive less investment from foreign investors.

Conclusions:  This paper provides a brief summary on research related to corruption and its impact on financial markets. Anecdotal evidence has shown the disruptive effect of corruption, and theoretical literature largely confirms this effect. Empirical studies show that the cost of corruption is highly significant in many different areas of the economy. In particular, across international financial markets, corruption is found to be associated with higher borrowing cost, lower stock valuation, and worse corporate governance.  Corruption imposes large costs on various countries.  It may be difficult to stem out corruption, but the payoff is large for those countries that succeed in doing so.



1.     David Ng. The impact of corruption on financial markets. Managerial Finance , September 2006 32(10):822-836. 

2.     Daniel Treisman. The causes of corruption: a cross-national study. Journal of Public Economics, Volume 76, Issue 3, June 2000, Pages 399–457.

3.     Francis T. Lui, Isaac Ehrlich. Bureaucratic Corruption and Endogenous Economic Growth. Journal of Political Economy, Vol. 107, No. S6, pp. S270-29, December 1999.

4.     Andrei Shleifer, Robert W. Vishny. Corruption. NBER Working Paper No. w4372.

5.     Ciocchini, Francisco, Erik Durbin and David Ng. 2003. Does Corruption Increase Emerging Market Bond Spreads? Journal of Economics and Business, v.55, pp. 503-28.

6.     Lee, Charles and David Ng. Corruption and International Valuation: Does Virtue Pay? Journal of Investment, 2009

7.     T R. Gaston Gelos, Shang-Jinwei. Transparency and International Portfolio Holdings. The Journal of Finance, DECEMBER 2005.

8.    Fisman, R. Estimating the value of political connections. American Economic Review, vol. 94 No.4, pp.1095-102.

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