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. It is widely recognized that FDI has the potential to affect market and political conditions in host countries. Whether these effects are positive or negative is likely to depend on the underlying economic and political environments in the host. The structure of the economy and the availability of local resources determines the possibility of extracting rents. And rent sharing is at the center of most instances of grand corruption. Political development, on the other hand, determines the level of accountability of the incumbent, creates a check on the ability to appropriate those rents, and increases the probability of getting caught and sanctioned for engaging in corrupt behavior especially in the presence of a multinational corporation. Hence, we argue that FDI will be associated with higher corruption levels in political and economic environments where competition is restricted. Assessing the relationship between FDI and corruption empirically presents a technical challenge: while inward FDI has the potential to affect corruption levels in the host countries, corruption is also likely to affect investment flows. Most studies to date tend to overlook this endogeneity problem. We test our hypotheses in a instrumental variable two-stage least-squares setting, finding preliminary support for our hypotheses: The effect of FDI on corruption is positive in authoritarian and poor countries, and turns negative as countries become more democratic. We also find that the marginal effect of FDI on corruption is negligible in more developed economies

Keywords: foreign direct investment, corruption, instrumental variables

JEL Classifications: D72, D73, F21, F23, C12

Working Paper Series