When Corruption Helps the Bottom Line

Michael S. Pagano is the Robert J. and Mary Ellen Darretta Endowed Chair in Finance at the Villanova School of Business.

Most investors would agree that less corruption and more transparency in financial markets are good things. But in a contrarian way, a high degree of corruption in foreign markets can actually be beneficial. And that may provide an interesting counterargument to recent enforcement actions.

The fact that large-scale corruption exists is not in dispute; in many foreign markets it is clearly “caveat emptor.” Actions by the Justice Department and the Securities and Exchange Commission under the Foreign Corrupt Practices Act in the United States are making front-page headlines almost on a weekly basis in recent years.

The Justice Department and the S.E.C. recently released guidance on the corrupt practices act, a law that has become problematic for many global companies. And many other countries around the world are also following suit with newly empowered regulatory agencies. In April 2011, Britain passed the Bribery Act, a major compliance regulation, to go after corruption.

Under this backdrop, Professors Pankaj K. Jain of the University of Memphis, Emre Kuvvet of Texas A&M and I set out to analyze just what effects corruption had on investment, cost of capital and market liquidity for institutional investors. We examined corruption and its effect on financial markets at the national level using data from 49 countries.

Our finding that investing conditions are extremely favorable in Denmark, one of the most transparent countries, makes logical sense.

What is surprising is that the most corrupt countries like Venezuela (which is at the very bottom of our list at No. 49) are actually better for investors than moderately corrupt countries like Morocco or Mexico.

This finding points to a “perverse level playing field” where potential investors in these extremely corrupt countries know who is in charge and can thereby succeed and prosper. But in moderately corrupt countries, it is unclear who is in charge and how to play the game.

Corruption is a result of several factors, including the increased pressure on investors and companies to compete for lucrative international business opportunities. As noted in a 2011 working paper, the benefits obtained by bribing officials or engaging in corrupt behavior can be quite tempting; it is estimated that the average return is 10 to 11 times the original bribe amount for 166 prominent cases in 20 countries.

We used several tools to help us quantify some of the effects of corruption on stock prices. Some of those included the corruption perceptions index data from Transparency International; data from Ancerno that gives company transaction costs for foreign stocks traded by more than 700 institutions in the home markets of 49 countries; and I.M.F. data on foreign portfolio investment flows in all 49 countries.

Based on these data, it was clear that corruption in the 49 countries that were studied directly affected their financial markets. Corruption directly affected stock liquidity (making it hard to quickly buy or sell a particular stock or bond), the cost of buying and selling stocks and the trading costs of stocks.

Corruption also affects the amount of foreign investment in a country as a percentage of gross domestic product, and the cost of financing corporate operations within a certain country. We discovered that, on average, corruption can reduce foreign equity investments by 70 percent, raise trading costs by 0.8 percentage points (that is, 80 basis points) and increase the cost of capital by up to 8.63 percentage points.

The presence of corruption also makes it hard for outsiders to value a security properly. Higher levels of corruption typically lead to greater investor uncertainty — and a wider gulf between what insiders and outsiders know about the value of a market’s stocks and bonds.

An answer to the problem, however, may lie in investing in education rather than in regulation. Our study also found that corruption was inversely related to the level of education in a country. So, more education typically relates to less corruption, and a country that wants to reduce corruption over the long run should promote and invest in education.

In the meantime, what is an investor to do? Because of the “perverse level playing field” that makes moderately corrupt countries unattractive, large investors looking at foreign markets might prefer to invest in the most corrupt nations (as well as the most transparent).

There are corporate costs to engaging in corruption, however. Our study also examined 27 publicly traded companies that ran afoul of the Foreign Corrupt Practices Act, including I.B.M., Chevron and Siemens.

We discovered that after each company was fined, its average trading costs and cost of capital were higher. These higher costs translate into a lower stock price for those firms that have been penalized under anticorruption laws.

So should investors ask for more regulatory enforcement of corrupt foreign exchanges? Of course, but the incentives for doing what is morally right and for what actually might make a profit may not be so clearly aligned.

Maybe government’s role in promoting education might be another, more effective way to realign these incentives so that the world can be more transparent and less corrupt in the long run.