Government corruption is a serious threat to stock market returns. It raises the cost of doing business, creates uncertainty and risk for investors, and erodes trust. This is especially damaging for emerging markets that seek to attract foreign investment, which rely on stock markets as their primary source of liquidity.
We study the impact of corruption and other institutional factors on stock market growth using a panel two-way fixed effect model with monthly data over the 1995-2014 period for BRIC countries. Corruption is one of the free (focus) variables, along with democratic accountability, bureaucratic quality and law and order.
Results show that a one percentage point increase in corruption has a negative marginal effect on stock market returns. This negative effect decreases as the level of democratisation increases, suggesting that democratic accountability mitigates some of the ill effects of corruption. However, it is important to note that a corrupt environment can also reduce bureaucratic quality and distort law and order. These interaction effects have interesting and mixed results, generating either positive or negative stock market returns depending on the specific context of the country.
The result suggests that a more transparent political environment is conducive to higher stock market returns and growth. This is likely because transparency enables the public to assess the degree of corruption in the country and its implications for investment. It also helps to limit the power of individuals in gaining influence and increasing the likelihood of punishment for ill-gotten gains.