Fortune or Evil? The Effect of Inward Foreign Direct Investment on Corruption

Abstract

This paper analyzes the relationship between inward foreign direct investment (FDI) and corruption. Previous studies report a negative eect of corruption on FDI inows; yet inward FDI has the potential to aect corruption levels in the host countries. We argue that the eects of FDI on corruption are conditional on the host country’s underlying economic and political climate. The underlying structure of the economy determines the possibility of extracting rents that could distributed among foreign investors and the incumbent. Political development, on the other hand, determines the level of accountability of the incumbent, and hence creates a check on the incumbent’s ability to appropriate those rents, and the probability of getting caught and sanctioned for engaging in corrupt behavior. Hence, in more democratic polities with a diversied economy, FDI inows are likely to be associated with lower corruption. In non-democratic countries with less diversied economies, a rise in FDI inows are more likely to be associated with higher corruption levels. Most empirical attempts to estimate the relationship between FDI and corruption overlook the latent endogeneity problem. We, on the other hand, construct an instrument for inward FDI per capita using a measure of remoteness, namely a weighted average of the geographical distance between the host country and the richest economies in the world. Ancillary tests suggest that the instrument -which is loosely related to a gravity model of investment- is strong and valid. We test our hypotheses on the conditional eects of FDI on corruption in a two-stage least-squares setting. Controlling for other factors identied in the extant literature as determinants of corruption, such as legal systems, religion, ethnolinguistic fractionalization, and national resources endowments, we nd preliminary support for our hypotheses of the conditional eect of FDI. The eect of FDI on corruption is positive in authoritarian and poor countries, and turns negative as countries develop and become more democratic. Yet we also nd that the absolute eect of FDI on corruption in democratic and rich countries is smaller.