Economists have been studying the effects of corruption on a variety of economic variables, like growth, inequality and innovation. This chapter investigates the impact of Transparency International's Corruption Perception Index (CPI) on the inflows of Foreign Direct Investment to Latin American Countries for the period 2012-2019. The choice of the period is due to the new methodology of the CPI which allows for comparisons between time periods. A panel data model is employed to investigate whether corruption “grease the wheels” or “sand the wheels” of FDI. Results show that the CPI exerts no influence on the inflows of FDI, at least for this time period and sample. The chapter also considered the criticism raised by Heywood (2017), who criticizes the very use of measures of perception of corruption as valid parameters to analyze the role of corruption on economic outcomes.
TopIntroduction
Corruption is a worldwide problem. According to the World Economic Forum1, in 2018 the costs of corruption amounted to 3.6 billion dollars. No doubt, this is a significant figure and merits some attention. Indeed, economists have been studying the effects of corruption on a variety of economic variables, like growth, inequality and innovation. For example, Dincer (2019) estimates a panel data model for 48 American states and finds that corruption has a negative impact on innovation. A few years earlier, Gupta, Davoodi & Alonso-Terme (2002) analyzed cross-sectional data for various countries and found a significant positive association between corruption and inequality, showing that this is still a topic with an open space for discussion.
As for growth, in an influential paper, Mauro (1995) shows that corruption negatively impacts economic growth, with a substantial reduction in investment. This result is confirmed in Mo (2001), Méon and Sekkat (2005). In this last study, the authors contrast two different hypotheses, the “grease the wheels” hypothesis and the “sand the wheels” hypothesis. The former hypothesis refers to the possibility that corruption might be beneficial for economic growth. The later hypothesis to the standard interpretation that corruption degrades economic performance. The reasoning behind the “grease the wheels” effect is that corruption arises when institutions are inefficient, therefore, corruption acts as a mechanism to compensate for sluggish public sector functioning (Rafay, 2023). Some works have provided evidence for the “grease the wheels” hypothesis, such as Dreher and Gassebner (2013), Méon and Weill (2010). But as Ugur (2013), Gründler and Potrafke (2019) have pointed out, the general empirical findings are pointing towards the “sand the wheels” effect of corruption.
If corruption is detrimental to growth, especially through depressing investments, this notion may be carried out to establish whether corruption cuts back the incentive to invest abroad. In particular, for emerging economies, foreign capital can be a crucial factor to relax the constraints imposed by inadequate levels of internal savings. As it is documented, for example in Calderon, Chong & Loayza (2000), Kandil and Greene (2002), Yurdakul and Ucar (2015), current account deficits are associated with economic growth. A current account deficit implies a surplus in the capital account, an inflow of capital from abroad to finance an increase in investments.
Since market-oriented reforms have taken place in the 1990s, an increase in capital flows is observed toward Latin American countries. However, as Edwards et al. (1999) indicate in a historical description of capital flows to Latin America, inflows of capital have been unstable, from being a target of intense inflows of capital in the first half of the 1990s to periods of instability and crisis in the second half. Given these instabilities, the determinants of capital flows to emerging market economies have been a subject of great interest to researchers.
In fact, the behavior of international capital flows is not entirely understood since Lucas (1990) posed the question as to why doesn’t capital flow naturally from rich to poor countries. It is expected, according to traditional economic theory that capital would flow from places where it is relatively abundant to places where it is relatively scarce, until the equalization of marginal returns on capital. However, this is not what is observed in the empirical literature.
Since this chapter focuses on foreign direct investment (FDI), the determinants of FDI are looked into, which are different from other types of capital flows. Speaking broadly, international capital flows usually follow a push-pull pattern. That is, there are specific factors that lead to an inflow of foreign capital into a given country. The push factors are external factors that increase the inflow of foreign capital into a country. The pull factors are internal factors which increase the inflow of foreign capital into a country. Using this framework, certain pull factors may be chosen that increase the inflows of FDI toward emerging market economies.