Corruption Uncertainty and Corporate Practices

Lambert here: The idea that corruption uncertainty is a bigger drag on “the economy” than corruption itself is provocative, but sensible: After all, if you know what the vig (bite, mordida, “tea money”) is going to be, you can account for it. It will be interesting to see when or if United States firms begin to engage in the sort of behavior described here.

By Jan Hanousek, Full Professor at CERGE-EI; Research Fellow at the William Davidson Institute, Michigan Business School, Research Fellow, CEPR, Anastasiya Shamshur, Senior Lecturer in Finance at Norwich Business School, University of East Anglia , and Jiri Tresl, Assistant Professor at Central Michigan University; Researcher at CERGE-EI. Originally published at VoxEU.

The idea that corruption hinders investments is not new, but rather is already well documented (Mauro 1995). However, the existing literature has solely examined the impact of average country-level corruption indices on investments. This is not fully consistent with how corporations make decisions. When corporations make forward-looking decisions like investments, expected levels of corruption are incorporated into the decision-making process, and therefore corporations worry more about uncertainties. Seminal theories thus focus on the impact of uncertainties on investments (Dixit and Pindyck 1994) – whose predictions are supported by notable empirical studies such as Leahy and Whited (1996), who find that general economic overall uncertainty lowers firm investment – and Bloom et al. (2007), who show that uncertainty with (partial) irreversibility reduces corporate investments. Recent works continue the exploration of the impact of uncertainties to understand further the extent to which they matter. Gulen and Ion (2016) find that corporate investments are lower when uncertainty about policy is higher in the US. Kim and Kung (2017) show that, as uncertainty increases, firms using fewer re-deployable assets reduce investments more than firms using more of them.

In a recent paper, we continue to explore the relationships between uncertainty and corporate investments, and focus specifically on corruption uncertainty (Hanousek at al.2017b). Measuring the portion of overall uncertainty attributable to corruption uncertainty is challenging. The difficulties are determined not only by the elicit nature of corrupt activities, but also by the availability of data. Our efforts join recent attempts to create a more granular corruption variable from the Business Environment and Enterprise Performance Survey (BEEPS) (Hanousek et al. 2017a, Hanousek and Kochanova 2016). BEEPS is an anonymous survey of firms from Central and Eastern Europe about local business practices, created in part by the World Bank Enterprise Survey (WBES) and in part by the European Bank for Reconstruction and Development (EBRD). It is known to be the most detailed source of data on corruption practices (Svensson 2003). Our corruption uncertainty measure reflects the variation in perception of corruption in a given environment (see Hanousek at al. 2017 for more details).

Investing under Corruption Uncertainty

Our final dataset contains more than 140,000 firm-level observations for 13 Central and Eastern European countries, from 2001 to 2013. Our results show that increasing corruption uncertainty has a negative impact on corporate investments. We also control for general economic uncertainty and corruption levels. The result holds – higher corruption is still associated with a decrease in investment. The results are not sensitive to alternative research designs, subsamples, and additional controls. High dispersion in corruption perception indicates high uncertainty about the corruption level in an environment.

Overall, we find, on average, that corruption uncertainty negatively impacts corporate investments. The higher the perception of corruption dispersion, the lower the invested capital. Nevertheless, these results are sensitive to the ownership structure of the firm. While domestically controlled firms scale back their investments when corruption uncertainty increases, firms with a foreign controlling owner are unaffected by the corruption uncertainty factor. There could be several reasons for this. First, when entering foreign markets, firms that want to remain foreign-controlled might interact with local government agencies/officials to settle any uncertainty. Second, since foreign firms are the subject of strict anti-bribery regulation (e.g. the US Foreign Corrupt Practices Act, the UK Bribery Act, and the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions) they self-select into environments where corruption uncertainty does not affect their business. These effects might seem to be indistinguishable from each other but, given that we control for firm fixed effects, it seems plausible that when foreign firms enter markets in which they want to hold the controlling hand, they self-select into industries where no corruption uncertainty exists – i.e. there is no variation in our corruption measure. Basic summary statistics would indicate that this is the case, as one can see from our paper.

Figure 1 Mean corruption uncertainty in 2012

Source: BEEPS data, authors’ computation. We acknowledge use of © EuroGeographics for the administrative boundaries for creating the map

Uncertainty Lowers Investments, but What Happens to the Uninvested Cash?

Typically, the decrease in investments is accompanied by an increase in cash holdings. We therefore further study the impact of corruption uncertainty on cash holdings. We find that the relationship is negative. Uncertainty usually dictates that companies hold more cash to protect themselves against adverse shocks. However, the bribery channel is also cash. Our results indicate that companies lower cash holdings on the balance sheet when corruption uncertainty increases. We hypothesise that the reason for this is that corporations need to build more off-balance sheet cash reserves to be prepared for the increased uncertainty about the misuse of bureaucratic power. The sensitivity of the ownership levels mirrors the results from the investment models. Only firms whose investment decision is affected by the corruption uncertainty respond by adjusting their cash holding.

Our results have several implications. First, they suggest that uncertainty about the corruption level can be even more harmful for the firm-level investments than high corruption itself. Second, our results indicate that firms have different sensitivity to corruption-induced uncertainty – different firms are affected to different degrees. Notably, majority-controlled foreign firms seem not to be sensitive to uncertainty. Third, corruption uncertainty implications for firms’ cash holdings open a fruitful avenue for further research. On the one hand, the decrease in cash holdings could be due to their expropriation by the majority shareholder. On the other hand, these off-balance sheet funds could be used to meet the demands of corrupt officials.

References in the original.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.