Corruption is a threat to economic and financial stability and leads to misallocation of resources – both in terms of human and material capital. It also distorts investments and leads to loss of investor trust. The Enron and Halliburton scandals, the BAE bribery of Saudi officials for fighter jets, and corruption in oil deals confirm that government corruption can affect both companies’ profits and investors’ investment returns.
However, little work has examined the stock market reaction to disclosure of a country’s corruption risk. We use a unique dataset revealing the corruption risk scores of 129 firms in the defence industry compiled by Transparency International (TI). We find that higher corruption risks reduce SR, while an increase in institutional quality moderates this effect. Moreover, the effect of corruption is stronger in autocratic countries than in democratic ones.
Using panel fixed effects and Arellano-Blundell-Bond linear dynamic panel data estimation, we find that the effect of corruption on SR diminishes with democracy but it has positive interaction with DA which may be due to the greasing the wheel effect that corruption provides for businesses when there is greater freedom. Similarly bureaucracy improves business practices and thereby increases SR but when distorted by corruption, it lowers stock returns. The implication of this finding is that anticorruption policies need to consider the heterogeneity among institutions. This is because some dimensions of institutions – such as democratic accountability, bureaucracy, and law and order – function differently when interacting with corruption and its impact on stock markets.