Corruption’s Impact on Liquidity, Investment Flows, and Cost of Capital

Abstract

Corruption decreases liquidity available to institutional traders and discourages foreign portfolio investment inflows into a country. Corruption also increases corporations’ cost of equity capital. The effects of corruption on foreign investment and the cost of equity capital are nonlinear and reverse J-shaped, with intermediate levels of corruption yielding the most negative effects. Highly transparent nations, where a “level playing field” exists between foreign and local investors due to lack of information asymmetries related to corruption, attract the most investment flows. However, at the margin, very corrupt countries attract more flows than moderately corrupt countries because a “perverse level playing field” in the former countries may put foreigners and locals on an even footing in terms of resolving asymmetric information problems.