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

This paper analyzes the relationship between inward foreign direct investment (FDI) and grand corruption. We argue that the effects of FDI on government 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 be distributed among foreign investors and the incumbent. Political development, on the other hand, determines the level of accountability of the incumbent, and 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, we argue, FDI will be associated with higher corruption levels in political and economic environments with restricted competition. In more competitive political systems with diversified economies, on the other hand, FDI inflows are likely to reduce the ability of the incumbent to engage in corrupt behavior. Assessing the empirical content of our argument presents several technical challenges. First, while inward FDI has the potential to affect corruption levels in the host countries, previous empirical research reports a negative effect of corruption on investment inflows. Most empirical attempts tend to overlook the endogeneity problem. We, on the other hand, adopt a strategy aimed at dealing with endogeneity: we construct an instrument for inward FDI based on a measure of remoteness. Ancillary tests suggest that the instrument -which is loosely related to a gravity model of investmentis strong and valid. We test our hypotheses on the conditional effects of FDI on corruption in a instrumental variable two-stage least-squares setting, finding preliminary support for our argument: The effect of FDI on corruption is positive in authoritarian and poor countries, and turns negative as countries develop and become more democratic. However, we also find that the marginal effect of FDI on corruption in democratic and rich countries is smaller.