Corruption, a pervasive issue in the developing world, is widely regarded as an obstacle to investment. Various evidence suggests that corruption reduces the space for investing in the economy and raises cost through bribes, pleasing powerful officials, and spending on entertainment to build networks (Wang and You, 2012).
Our analysis using panel data on BRIC countries estimates with fixed effects and dynamic panel estimation reveals that government corruption has negative but moderate effect on stock market returns (SR) primarily due to its adverse impact on firms’ production efficiency. This in turn raises costs and erodes confidence for investors.
However, the interaction of corruption with institutional factors such as democracy, bureaucratic quality and law and order shows interesting mixed results. While democracy can mitigate the ill effect of corruption through its signaling function by increasing returns, bureaucratic quality can improve stock market performance by greasing the wheel and reducing red tape, while corrupting law and order distorts this positive interaction.
In addition, we find that SR is positively associated with global and emerging markets indices suggesting complementarity in returns. Moreover, the results reveal that stock prices of firms with lower corruption risk experience less volatile and more liquid stocks than those with higher corruption risk. This finding is consistent with the reputational loss hypothesis that explains why firms may disclose their lower corruption risk to attract investors. For example, the arrest of the CEO of defence company Finmeccanica for alleged bribery over a helicopter sale to India caused a decline in its share price and led to media criticism.