Government corruption is a significant problem around the world. It warps policy and allows those with the most money to take advantage of the system. It can result in the misallocation of public resources – for example, in the United States during the Gilded Age, corrupt political leaders allowed robber barons to avoid regulation and gobble up public resources while workers struggled with overcrowded housing, poor sanitation and meager wages. Corruption also stifles innovation and lowers economic growth.
Whether it is bribing tax inspectors to get more cash, paying officials for access to business opportunities, or rigging elections, corruption makes it more difficult for businesses to compete in global markets. It can even lead to stock market crashes and financial crises that cost people their life savings.
Existing research on the impact of corruption on financial markets is mixed. Some findings suggest that corruption is a negative driver of volatility (Zhang and You, 2012) while Lau et al. (2013) found that disclosure of lower corruption risk reduces stock market volatility. One reason for these conflicting results may be different financial market structures across countries, which could skew the effects of corruption on volatility.
Using a panel two-way fixed effect model with monthly data and the variables democratic accountability, bureaucratic quality and law and order, we find that corruption negatively affects stock market returns in BRIC countries. The interaction effect with democracy is positive indicating that as the level of transparency increases, the marginal impact of corruption on stocks diminishes.