The Price of Corruption

To what degree does corruption affect economic growth in emerging markets? To answer this question, development institutions must find ways to measure corruption and the efforts to fight it. According to the World Bank Institute,

“This recognition has renewed interest in the World Bank, and among aid donors, aid recipients, investors, and civil society, in developing measures of corruption, both in aid-financed projects as well as more broadly in developing countries. This in turn has also sparked debate on how best to measure corruption and monitor progress in reducing it.”

One way to address this problem is to measure the rates charged for debt issued in specific emerging markets. By understanding how corruption affects lending, we can see the direct cost to businesses, governments, and citizens who receive loans. We need to gauge the true costs of corruption based on something more than perception. Examining bond spreads over the short and long term ultimately allows organizations to gauge the effectiveness of institutional anti-corruption efforts.

Higher corruption increases risk, which may directly influence borrowing costs. While corruption affects many other parts of economic growth, borrowing ability is a key determinant of overall growth. What does corruption do to government debt? Corruption means that the lender runs the risk that loaned funds will be commandeered, or that the tax receipts that would have been used to pay off national debt are instead embezzled. Either way, corruption lowers a government’s ability to utilize loan funds and pay them as due.

Corruption increases the related risk for corporate debt in three ways. It raises the likelihood for arbitrary and punishing government actions (often coming as a result of minimal democratic governance) that eat into profit and decreases the ability of companies to plan for the future. Additionally, government services are corroded and made less effective. One consequence of this is that controlling shareholders or corporate principles are able to divert resources for personal gain, owing to a lack of oversight or an ability to work around it. Finally, corruption impairs the legal protection for bond holders, significantly increasing their risk.

How can we prove this?

The bond market prices the risk of corruption into the yield, or the amount that the lendee pays the lender for assuming the credit risk of non-payment. What results is a bond spread, or the difference between the yield on a benchmark security, like a US Treasury bond, and the yield from a security with a higher credit risk. What we want to know is whether the level of risk posed by corruption to a government or corporation is measured in the bond spread between baseline lending rates and the emerging market rate.

As corruption goes, so goes the bond spread

If there is a link between risk and the bond spread – and we have seen how corruption increases risk – a lower rate of corruption should result in a smaller bond spread, and vice versa. As Ciocchini, Durbin, and Ng found, a reduction in perceived corruption by one point lowers the bond spread by about 1/5, or 53 basis points for the average bond. The effect of corruption on bond spreads holds across different regions and type of bonds (corporate and sovereign). This is only the immediate effect of corruption. We may safely assume that lower corruption raises general economic growth, for instance, and higher growth also leads to lower bond spreads due to the decrease in default risk (in addition to a marginal increase of 1/5 as seen above).  

How can these findings be used?

What we are beginning to see is that corruption has a direct and measureable effect on the financing that drives an economy. For private organizations and governments, the bond spread highlights a punishing externality that reduces return for shareholders and taxpayers alike. This analysis increases the awareness and knowledge of those tasked with fighting corruption, based on stable and comparable data.

By tracking the rise and fall of bond spreads in countries afflicted with institutionalized corruption, international development organizations can measure political and economic risk to their organizations, grants, and partners.  Development institutions can also demonstrate the reward for positive behavior by developing countries and their businesses, drawing a direct link between fighting corruption and increasing economic growth. Finally, by comparing year-by-year bond spreads and corruption perception surveys to organized anti-corruption efforts (controlling for other macro-economic factors), development institutions can gauge the effectiveness of their own work. Bond spreads appear to offer a critical insight to institutions and governments looking to harness every tool and expend precious resources to address the malignant influence of corruption.