Local Corruption and Global Capital Flows

The research reported in this paper was inspired by a plane ride I took from China to the United States in 1996. Browsing the newspapers and in-flight magazines, I came across one story about the high level of official corruption in China, and another that extolled the extraordinarily large flow of foreign direct investment (FDI) into China that year.¹ Later in the flight, I struck up a conversation with the passenger sitting next to me, an American business executive who had just visited his joint venture firm in China. I asked him whether the corruption problem in China affected him and his business. He said that it did and went on to explain the myriad problems that his firm had encountered in dealing with corruption and bureaucratic red tape.

During and after that flight, I reflected on whether corruption has generally worked as a beneficial "grease," a minor annoyance, or a major obstacle for international investors. In this paper I address three interrelated issues. First, does corruption reduce inward FDI? Second, is China an exceptional case in which corruption does not do much harm? Third, does corruption distort the composition of capital inflows in a way that might raise the likelihood of a currency crisis?

International direct investment reached $3.5 trillion in 1997. A small number of countries in the industrial world account for the bulk—about 68 percent—of this investment.² Yet international direct investment is especially important for developing countries, for which it is not only a source of scarce capital but also an important conduit for the transfer of technological and managerial know-how.³

The recent currency crises in East Asia, Russia, and Latin America have highlighted the importance of the composition of capital flows for developing countries. Before I attempt to explain the relationship between corruption and the composition of capital inflows, it is worth noting that there are at least two views on the causes of these crises. One increasingly widespread view is that so-called crony capitalism—the misallocation of financial resources to the friends and relatives of government officials—is partly responsible. However, there is so far virtually no systematic evidence to support or reject this hypothesis.⁴ The other view is that the confidence of international creditors in developing economies is fragile, so that small changes in the outlook can give rise to self-fulfilling expectations of a crisis.

These two explanations are typically presented as rivals, but there may be a link between them. The extent of corruption in a country may affect that country's composition of capital inflows in a way that makes it more vulnerable to shifts in international creditors' expectations. Corruption here refers to the extent to which firms or individuals need to pay bribes to government officials to obtain permits, licenses, loans, or other government services needed to conduct business in a country.⁵

Several studies have shown that the composition of international capital inflows is correlated with the incidence of currency crises.⁶ They have found that the lower the share of FDI in total capital inflows, or the higher the ratio of short-term debt to reserves, the more likely a currency crisis becomes. One possible reason is that bank lending or other portfolio investment may be driven more by sentiment than direct investment is. Hence a small, unfavorable change in the recipient country's fundamentals may cause a large swing in portfolio capital flows, from massive inflows to massive outflows. This can strain the country's currency or financial system sufficiently to cause or hasten its collapse.⁷ To my knowledge, no studies have examined the connection between corruption (or the intrusiveness of national bureaucracy more generally) and the composition of capital inflows. This paper seeks to fill that void.

A small number of previous papers have looked at the effect of corruption on FDI. Combining corruption with twelve other variables to form a composite indicator, Ashoka Mody and David Wheeler failed to find a significant relation between corruption and foreign investment.⁸ However, this result may have been due to a high...