Corruption and Foreign Direct Investment. Evidence from Central and Eastern European States

Amarandei, Cristina Mihaela Article Corruption and Foreign Direct Investment. Evidence from Central and Eastern European States CES Working Papers Provided in Cooperation with: Centre for European Studies, Alexandru Ioan Cuza University Suggested Citation: Amarandei, Cristina Mihaela (2013) : Corruption and Foreign Direct Investment. Evidence from Central and Eastern European States, CES Working Papers, ISSN 2067-7693, Alexandru Ioan Cuza University of Iasi, Centre for European Studies, Iasi, Vol. 5, Iss. 3, pp. 311-322 This Version is available at: https://hdl.handle.net/10419/198251 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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EVIDENCE FROM CENTRAL AND EASTERN EUROPEAN STATES Cristina Mihaela Amarandei * Abstract: This paper examines the impact of corruption on foreign direct investment inflows for ten Central and Eastern European states. The paper attempts to answer the question: what is the role of corruption in attracting foreign direct investments? Using the data from UNCTAD for foreign direct investment and Corruption Perception Index from Transparency International, for a period of 12 years, 2000-2012, we evaluate the specific impact of corruptions on FDI using GDP as control variable. Our results confirm the majority of literature and show a negative significant relation between the variables analyzed, but at a lower intensity than expected. Keywords: foreign direct investment; institutions; corruption. JEL Classification: D73; E02; F21. INTRODUCTION Taking into consideration the CEE states, after the 1989 moment, foreign direct investment was seen as the best solution for national economic development. As Dunning (1993, p. 20), for example, has argued that multinational companies „are uniquely able to supply many of the necessary ingredients for economic growth, a reshaping of attitudes to work and wealth creation, the redesigning of the business and legal framework, especially with respect to property rights and contractual relationship”. Institutions have an essential role in setting the „rules of game” by which individuals interact in a market economy (North, 1990), especially by ensuring the competiveness of markets. After the 1989 events, the countries from Eastern Europe looked at foreign examples in building its institutions and reforming their economies. Still, new institutions were created without taking into to consideration that the distinct cultural and systematic inheritance influences especially informal institutions such as norm and values. In many countries weak legal framework permitted a large extent of opportunistic behavior, bribery and corruption (Nelson et al., 1998). * PhD. Candidate, Alexandru Ioan Cuza University of Iasi, Romania, e-mail: [email protected]. CES Working Papers – Volume V, Issue 3 312 Looking at the literature that examines in which extent the quality of institutions plays an important role in the development of an economy we found conflicting results. In general, many studies demonstrated that bad governance fosters corruption and can lead to inefficient allocation of resources and impede economic progress. Many authors, such as Gyimah-Brempong (2002), Mo (2001), Li et al. (2000) and Mauro (1995) had found that corruption has significant adverse effects on economic growth. Corruption can also create obstacles to doing business, according to World Bank (2002), deter foreign direct investment flows (Wei, 2000), cause misallocations of public expenditures (Mauro, 1997; Tanzi and Davoodi, 1997) or reduce rates of investment. There are many ways in which corruption can impact on economic behaviour and impose economic losses on society: it can damage incentives and destroy opportunities; it can distort price signals and deplete resources; and it can create uncertainty and compromise public policy. Our study presents the effect of corruption and market potential on foreign direct investment for 10 Eastern European countries for a period of 12 years. The results show that the level of corruption deters foreign investment inflows. The research has the following structure. Section 1 presents the theoretical approach on foreign direct investment, corruptions and a short literature review of econometric studies on the subject. Methodological aspects and results are presented in Section 2 and conclusions in Section 3. 1. THEORETICAL APPROACH ON FOREIGN DIRECT INVESTMENT, CORRUPTION 1.1. Determinants of FDI The process of economic globalization appears in the form of international trade in goods in services, short-term capital movements among countries and a rapid increase in foreign direct investment (FDI). FDI refer to long term cross-border investment with a substantial influence both on receiving country and on the investing multinational company. Two main types of determinant factors: the gravity factors and the policy related factors are suggested by the empirical literature regarding the determinants of FDI. The gravity factors refer to issues such as market size and the proximity of the host country to the source country and have been found to explain a big part of FDI flows. Policy related factors regard overall macroeconomic CES Working Papers – Volume V, Issue 3 313 stability, trade policies (trade costs, openness degree), fiscal policies (average taxation rate or the fiscal burden, tax incentive), labour policies (labour costs and skills), the degree of regional integration, infrastructure and institutions. Concerning the magnitude and sign of FDI determinants for Central and Eastern European States, many of the studies show ambiguous results when analyzed the mode of entry, the type of FDI or the target industry. Regarding to the relation between determinants of FDI, the table below summarize some empirical studies: Table 1 - Determinants of foreign direct investment Variables Sign of the relation Positive Negative Insignificant GDP/capita Schneider and Frey (1985) Birsan and Buiga (2009) Jaspersen et al. (2000) Wei (2000) Hausmann and Fernandez-Arias (2000) Political risk Schneider and Frey (1985) Edwards (1990) Gastanaga et al. (1998) Moosa and Cardak (2006) Loree and Guisinger (1995) Jaspersen et al. (2000) Hausmann and Fernandez-Arias (2000) Corruption Eagger and Winner (2005) Wei (2000) Akcay (2001) Source: author representation based on the studies presented. The available empirical findings based on EU countries make it difficult to draw general conclusions about the source of heterogeneity in the determinants of FDI for Central and Eastern European countries. 1.2. FDI and corruption It is a large debate surrounding the definition of corruption, many authors expressing different approaches on the subject. The narrowest approach specifies that corruption is „the use of public office for private gain”. The abuse of not only the public office but also the private or commercial takes part of the broad approach. CES Working Papers – Volume V, Issue 3 314 Theoretically, we must distinguish between „grabbing hand” and „helping hand” influences of corruption on inward FDI. In the short run, corruption raises the cost of a firm’s foreign investment, since (i) firms have to pay bribes (similar to taxes), (ii) they are engaged in resource-wasting rent seeking activities (Applebaum and Katz, 1987; Murphy et al., 1991; Shleifer and Vishny, 1993), and (iii) they have to bear additional contract-related risks, because corruption contracts are not enforceable in courts (Boycko et al., 1995). Corruption in the host country thus acts as a grabbing hand, reducing the profits of firms and therefore lowering a firm’s incentives to invest abroad. Further, corruption reduces the productivity of public inputs (infrastructure) which, in turn, decreases a country’s locational attractiveness (Bardhan, 1997; Rose-Ackermann, 1999; Lambsdorff, 2003). On the other hand, multinational firms might be willing to accept paying bribes in order (i) to speed up the bureaucratic processes to obtain the legal permissions for setting up a foreign plant (Lui, 1985), and (ii) to gain access to publicly funded projects (Tanzi and Davoodi, 2000). In this case, corruption acts as a helping hand, increasing profits of multinational firms. If the revenue effects outweigh the cost effects, corruption is expected to increase FDI. In the presence of pre-existing government and/or bureaucratic failures, however, corruption may be efficiency-enhancing (Bardhan, 1997; Aidt, 2003). Corruption then may also be rent-creating, with the rents from controls over foreign investment shared by corrupt officials and foreign investors. Glass and Wu (2002) focus on the impact of corruption on FDI in a general equilibrium model with Northern innovation and Southern imitation (Grossman and Helpman, 1991). Multinational firms are vertically organized and shift their production to the low cost country. The firms bear the risk of illegal imitation of their innovations, and of the requirement to pay bribes to public officials. Analyzing four types of bribes (bribes on sales or profits as well as repeated and one-time bribes in order to obtain a permission to sell in the foreign market), Glass and Wu (2002) demonstrate that the general equilibrium effects of corruption on FDI are in principle ambiguous, and conclude (Glass and Wu, 2002, p. 19) that „corruption need not be bad for FDI..., but rather corruption may foster inward FDI”. 2. ECONOMETRIC ANALYSIS Our model is based on theoretical approach found in academic literature. In order to isolate the effect of corruption on foreign direct investment we also use control variables such as GDP. CES Working Papers – Volume V, Issue 3 315 𝐹𝐷𝐼𝑖,𝑡 = 𝛼 + 𝛽1𝐶𝑃𝐼𝑖,𝑡−1 + 𝛽2𝐺𝐷𝑃𝑖,𝑡−1 + 𝜀𝑖,𝑡, where 𝒊 is the country subscript, 𝒕 is the time subscript, 𝜷𝒏 are unknown parameters to be estimated, 𝜺𝒊,𝒕 is the usual random disturbance term. All independent variables are lagged one year in order to avoid simultaneity with the dependent variable and taking into account that decisions to invest abroad take time. 2.1. Data variables FDI inflows are drawn from UNCTAD database for 10 countries form Central and Eastern Europe: Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. In the examination of corruption the most used measure is the Corruptions Perceptions Index (CPI) reported annually by Transparency International. This non-governmental organization studies corruption since 1995 looking to draw attention on the damage caused by corruption and to stimulate governments to adopt and implement anti-corruption regulations. The CPI ranges from zero (totally corrupt) to ten (absence of corruption). The index is based on surveys filled by specialists and calculated annually for a wide range of countries. We also use as control variable the real GDP for the countries analyzed. The table below shows the variables used in our analysis. Table 2 - Description of the variables Measure Data Source(s) Calculation Observed Foreign direct investment (FDI) Inward of foreign direct investment in millions USD Log FDI 2000-2011 Corruption Perception Index (CPI) Transparency International draws on 13 data sources from 11 globally dispersed institutions for this index. It ranges from 0 to 10, with high values indicating absence of corruption*. The CPI is a composite index using data compiled or published between 2000 and 2001 for the 2001 measure. Specifically, it is computed as an unweighted average of all estimates for a particular country. Currently, 183 countries are assessed. 2000-2011 GDP – proxy for market potential UNCTAD database real GDP in millions US dollars 2000-2011 *Transparency International Methodology, question 8, http://www.transparency.org/cpi2011/in_detail CES Working Papers – Volume V, Issue 3 316 2.2. Results and interpretation Our analysis uses the multivariate regression technique. The results show that, according to the Correlations table, between foreign direct investment and the perceived corruption is a negative significant relation, respectively a rise in the perception of corruption for the countries analyzed deter the expected inflows of FDI for the next years. Also it can be noticed a moderate direct relation between market potential and foreign direct investment received by the Central and Eastern European countries. This founding can be explained by the inclusion in the sample analyzed of the Baltic states who have a small GDP compared with the rest of the sample and high levels of foreign direct investment. Correlations matrix FDI CPI_1 GDP_1 Pearson Correlation FDI 1.000 -.269 .646 CPI_1 -.269 1.000 -.105 GDP_1 .646 -.105 1.000 Sig. (1-tailed) FDI . .001 .000 CPI_1 .001 . .127 GDP_1 .000 .127 . N FDI 120 120 120 CPI_1 120 120 120 GDP_1 120 120 120 Source: author calculations using SPSS 17. Table bellow shows that the model chosen for our analysis is significant (.Sig<.005) and adequate. Still, the Model Summary table shows that our model could be improved in order to have better values of R and R square by adding other institutional variables in equation beside corruption like democracy, government stability, law and order, democracy and the quality of bureaucracy. CES Working Papers – Volume V, Issue 3 317 Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate Change Statistics R Square Change F Change df1 df2 Sig. F Change 1 .677a .458 .449 3327.20174 .458 49.428 2 117 .000 a. Predictors: (Constant), GDP_1, CPI_1 Source: author calculations using SPSS 17. The qualitative assessment of the impact of corruption on FDI for the countries analyzed confirms the results of empirical analysis. First of all, the figure 1 shows that Romania and Bulgaria are considered highly corrupted countries. The evolution of the perceived corruption improved over time only for Romania, while Bulgaria marked a decrease of the CPI Index. Regarding to FDI inflows attracted by Romania and Bulgaria we can observe that are correlated with the evolution of CPI index. The decrease of the measure of corruption (meaning a rise in the perceived corruption (0-highly corrupted to 10 – very clean)), correspond with lower values of FDI inflows in the next year. Figure 1 - The evolution of FDI and CPI for Romania and Bulgaria Source: UNCTAD and Transparency International. Baltic States, Slovakia and Slovenia show the same evolution as Romania and Bulgaria (see figure 2). Still, we must mention that Lithuania, Slovakia and Latvia are perceived as more corrupted countries than Slovenia and Estonia. We must mention that the most free of corruption country of ECEC is Estonia with a CPI score higher than 6.0. 0,0 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 0,00 2000,00 4000,00 6000,00 8000,00 10000,00 12000,00 14000,00 16000,00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Corruption Perception Index Foreign direct Investment Romania Bulgaria CES Working Papers – Volume V, Issue 3 318 The highest level of FDI inflows are attracted by Slovakia even if the CPI index shows the lowest levels for the countries analyzed. These results can be explained by the active policy promoted by the Slovak government for attracting foreign direct investors (mainly fiscal incentives). Figure 2 - The evolution of FDI and CPI for Baltic States, Slovakia and Slovenia Source: UNCTAD and Transparency International. Analyzing Poland, Hungary and Czech Republic we can observe a mainly indirect relation between foreign direct investments and CPI. Czech Republic and Hungary have a particularly trend of the perceived corruption showing the same evolution. After a period of reforms and concrete efforts in reducing corruption, the emergence of the economic crises in 2008 marked decreases in the levels of corruption perception index and in FDI inflows. Poland stands alone in the group (see figure 3). We can see that even if the effect of the economic crises reflects in the levels of FDI inflows, the perceived corruption is constantly improving from 2005 to 2011. 0,0 1,0 2,0 3,0 4,0 5,0 6,0 7,0 8,0 -1000,00 0,00 1000,00 2000,00 3000,00 4000,00 5000,00 6000,00 7000,00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Corruption Perception Index Foreign Direct Investment Estonia Letonia Lituania Slovacia Slovenia