Corruption linked to currency crises in developing countries

February 26, 2002

Free Market Foundation

Rampant public corruption in emerging market countries may contribute to the currency crises that have racked the developing world, because corruption acts to repel more stable forms of foreign investment and leaves countries dependent on volatile foreign loans to finance growth.

Researchers Shang-Jin Wei and Yi Wu make the following case:

The most dependable kind of foreign investors those disposed to long-term commitments to projects and businesses often refuse to put their money in developing countries where, for example, local bureaucrats expect bribes and the national government arbitrarily preys on business enterprises.

Those countries still need foreign capital, and while they may be unattractive for foreign direct investment (FDI), they may not be equally disadvantaged when it comes to obtaining bank loans from international creditors.

One reason loans are easy to procure even when corruption is widespread is that the International Monetary Fund and governments of developed nations offer considerably more insurance and protections to lenders than to direct investors.

The result is an investment portfolio heavily skewed toward loans, and given how foreign lenders are known to flee at the first sign of trouble while those directly invested in an enterprise tend to sit tight such an imbalance leaves an economy much more vulnerable to a currency crisis.

Wei and Wu argue that, by discouraging stable flows of investment capital, corruption whose measure they derive from international surveys can be viewed as a sort of corporate tax on assets. For example, they conclude that “…an increase in corruption from the level of Singapore to that of Mexico would have the same negative effect on…foreign investment as raising the marginal corporate tax by 50 percentage points.”

Source: Matthew Davis, How Corruption Causes Currency Crises, NBER Digest, August 2001; based on Shang-Jin Wei and Yi Wu, Negative Alchemy? Corruption, Composition of Capital Flows, and
Currency Crises, NBER Working Paper No. 8187, March 2001, National Bureau of Economic Research.

For NBER Digest text http://www.nber.org/digest/aug01/w8187.html

For more on Currency Issues http://www.ncpa.org/pi/internat/intdex2.html

FMF Policy Bulletin\20 February 2002