Credit and Corruption

Abstract

Developed economies are usually characterised by high levels of governance and observance of the rule of law, with their macroeconomic outcomes being largely unaffected by corruption. In middle and low-income countries, however, corruption often has discernible negative consequences to the aggregate economy. We propose a theoretical framework that analyses the mechanisms through which corruption may reduce the supply of credit, by affecting a lender's expected reparation when a defaulting debtor is taken to court. We find that corruption adversely affects a creditor's expected reparation even if a defaulting debtor has no real chances of winning the litigation. In addition, corruption causes a creditor's expected return to decline with judicial costs even if it is the losing litigant (the debtor) who has to incur them. In the model, society's willingness and ability to punish corruption is found to be so important that it can induce 'honest' litigation procedures even if the probability of the case being heard by a corruptible court is made arbitrarily high. Finally, the negative influence of corruption on credit appears to be corroborated by a simple cross-section econometric exercise, in which credit as a proportion of GDP is explained by corruption indices and control variables.