THE EFFECTS OF CORRUPTION ON FOREIGN DIRECT INVESTMENT

INFLOWS: THEORECTICAL AND EMPIRICAL EXPLANAIONS

Introduction:
Can corruption facilitate foreign direct investment inflows? On the face of it, this
seems an implausible and controversial proposition. But the literature knows two opposing
theoretical positions regarding the effect of corruption on foreign direct investment (FDI)
inflows. On one hand, the 'grabbing-hand' theory of corruption claims that corruption has
a negative impact on the level of investment and economic growth (Mauro 1995), on the
quality of infrastructure and on the productivity of public investment (Tanzi and Davoodi
1997), on health care and education services (Gupta, Davoodi, and Tiongson 2000), and on
income inequality (Gupta, Davoodi, and Alonso-Terme 1998; Li, Xu, and Zou 2000: in AlSadig, 2009). For example, in a survey of international business managers by Kaugmann
(1997) the costs of investing in a more corrupt host country were shown to be as much as
20% higher than those of a less corrupt one. Smarzynska and Wei (2000) use firm-level
data and provide with evidence of corruption reducing FDI in Eastern Europe and the
former Soviet Union. Lambsdorff and Cornelius (2000) show an adverse impact of
corruption on FDI for African countries. Using a single source country, Voyer and Beamish
(2004) use cross-sectional regressions to investigate the effects of the level of corruption
on Japanese FDI in 59 developed and developing host countries. They find that Japanese
FDI is negatively related to the level of corruption particularly in developing countries.
Based on this line of reasoning, corruption in a host country will increase the costs of
foreign investors and will hence discourage FDI. This argument is supported by the
empirical studies of Wei (2000a, 2000b), Javorcik and Wei (2009), Egger and Winner
(2006) Busse and Hefeker (2007) and Hakkala et al. (2008) for both developed and
developing countries.
On the other hand, some scholars argue that corruption can be a 'helping-hand' in the
economy (Lui,1985; Beck and Maher , 1986; Bjorvatn and Soreide, 2005). In particular,
the efficient grease hypothesis argues that corruption could increase investment as it acts
as grease money that enables firms to avoid bureaucratic red tape and expedite the
decision making process (Huntington 1968; Leff 1964). For example, Cuervo-Cazurra
(2006) examined the relationship between corruption and FDI using data on bilateral FDI
inflows from 183 home to 106 host countries. They find that corruption results in relatively
higher FDI from countries with high levels of corruption. Egger and Winner (2005)
corroborated that corruption can be beneficial in circumventing regulatory and
administrative restrictions concluding that, indeed, corruption encourages FDI.

Colombatto (2003) also analyzes corruption theoretically in a variety of different

institutional environments and finds that in some cases corruption can be efficient in
developed, developing as well as in totalitarian countries. As Elliot (1997: 186) points out
bribes are viewed not only as reasonable but as enhancing efficiency in situations where
red tape or state control of the economy may be strangling economic activity. But this
view has been empirically rejected. For example, Kaufman and Wei (1999) using firm level
data covering more than 2,000 firms find that firms paying more bribes spend more time
negotiating with bureaucrats.
Meanwhile, recent findings suggest that the effects of corruption on FDI depend on the
countrys rule of law, culture, sound institutions, regime types and economic freedom.
However, what has been omitted from existing studies is the use of cross-sectional rather
than a panel data analysis to examine the effects corruption on FDI (with the exception of
Abed and Davoodis, 2000). Cross-sectional data cannot control for the unobserved
country-specific effects that may vary across countries and may be correlated with
corruption. Moreover, if a panel data analysis is implemented; those studies have ignored
the fact that corruption is not necessarily an independent variable. It is a consequence of
economic and noneconomic variables and so must be treated as an endogenous variable.
Accordingly, this study attempts to build empirical models to investigate the relationship
between foreign direct investment (FDI) and corruption and identify the determinants of
corruption in Africa. More specifically, this study differs from existing literatures in three
aspects. First, this study examines macro-level impact of corruption on FDI, not on the
micro-level, firm-based study. Second, this study focuses on Africa and not a mix of
developed and developing countries. Third, this study uses a cross-sectional analysis as an
initial step to confirm the findings of previous studies. Thereafter a panel data analysis will
be employed. This approach has distinct advantages of reliability and robustness of results.
Overall, the study seeks to provide theoretical contributions and policy advice for our
understanding of, and response to, the politics of corruption and its effects on FDI in
Africa.