A stock market crash may occur if investors discover corruption in a firm, or when investors lose confidence in the integrity of the market (Seymour, 1990). Corruption is an increasingly serious problem in emerging economies. It has been shown to affect investment, economic growth and social development (e.g., Shen, 2008; Cao, Xia, and Chan, 2016). While previous literature has explored the impact of firm-level factors on stock price crash risk, little attention has been paid to government corruption as a potential cause of a market crash.
In this paper, we explore the relationship between corruption and stock market returns in BRIC nations. We find that corruption has a negative impact on stocks, but this effect is moderated by institutional components such as political instability, investment profile and democratic accountability. In addition, we find that higher control of corruption has a positive impact on stock returns.
We use monthly data for a sample of 57 countries, and employ Extreme Bound Analysis along with panel fixed effects and a dynamic panel to estimate the effect of corruption on stock returns. We also explore the impact of a series of control variables such as political instability, investment profile and democracy on our main model. We also use Arellano-Bover and Blundell-Bond linear dynamic panel data estimations to resolve endogeneity issues utilizing lagged dependent variable estimates. We conclude that corruption is a significant factor in determining stock market returns, and this impact increases with the degree of democracy. In addition, corruption is a major predictor of the likelihood of a stock market crash, and this risk decreases with greater democratic accountability.