Corruption indicators, foreign capital, and economic growth in developing countries

Developing countries have experienced an unprecedented flow of foreign capitals from three main sources: foreign aid, foreign direct investment (FDI), and remittances, namely, the private transfers from immigrant workers back to their home countries. These funds might sound good news for countries historically constrained by limited savings and financial resources. However, these same economies have productive structures embedded in weak institutional frameworks, poor governance and corruption, hindering the effective use of foreign capital on productivity and economic growth. We undertake a comparative analysis of these three foreign capital inflows in developing countries for a period of 30 years, from 1985 to 2014. Different from the conventional approach of selecting a single source of foreign capital, and a single indicator to assess corruption in a country, we identify 10 corruption indices and evaluate their effect on these three sources of foreign capital and GDP growth. We applied different econometric methods. For comparative purposes, we provide results under ordinary least square (OLS), and subsequently complete the analysis under two-stage-least square (2SLS) and a generalized method of moments (GMM) to address possible endogeneity bias in the results. We find that FDI and remittances are important factors explaining economic growth, and their effects are enhanced after controlling for corruption. We also find that a foreign capital treated independently in a regression analysis would produce over-valuated parameters. For instance, the effect of FDI on economic growth is consistently smaller when incorporating remittances and foreign aid in the model. As expected, some corruption indices provide stronger explanatory power than others; thus, empirical researchers should use caution when selectively employing these indices. The results in this study lead to the relevance of corruption in explaining poor economic performance in developing countries. Nonetheless, it would be simplistic on our part to recommend countries to combat institutional corruption. To undertake this task requires large financial resources and a political will to produce changes within the political and regulatory systems. It would also require some degree of assistance from international organizations.