Corruption and the Composition of Foreign Direct Investment: Firm-Level Evidence

25 Pages Posted: 20 Apr 2016

See all articles by Shang-Jin Wei

Shang-Jin Wei

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Beata Smarzynska Javorcik

University of Oxford - Department of Economics; World Bank - Development Research Group (DECRG); Centre for Economic Policy Research (CEPR)

Date Written: November 1999

Abstract

The extent of corruption in a host country affects a foreign direct investor's choice of investing through a joint venture or through a wholly owned subsidiary. Corruption reduces inward foreign investment and shifts the ownership structure toward joint ventures.

Smarzynska and Wei study the impact of corruption in a host country on foreign investors' preference for a joint venture or a wholly owned subsidiary.

Their simple model highlights a basic tradeoff in using local partners. On the one hand, corruption makes the local bureaucracy less transparent and increases the value of using a local partner to cut through the bureaucratic maze.

On the other hand, corruption decreases the effective protection of an investor's intangible assets and reduces the probability that disputes between foreign and domestic partners will be adjudicated fairly, which reduces the value of having a local partner.

As the investor's technological sophistication increases, so does the importance of protecting intangible assets, which tilts the preference away from joint ventures in a corrupt country.

Empirical tests of this hypothesis on firm-level data show that corruption reduces inward foreign direct investment and shifts the ownership structure toward joint ventures. Conditonal on foreign direct investment taking place, an increase in corruption from the level found in Hungary to that found in Azerbaijan decreases the probability of a wholly owned subsidiary by 10 to 20 percent. Technologically more advanced firms are less likely to engage in joint ventures, however.

Smarzynska and Wei find support for the view that U.S. firms are more averse to joint ventures in corrupt countries than are other foreign investors - possibly because of the U.S. Foreign Corrupt Practices Act, which stipulates penalties for executives of U.S. companies whose employees or local partners engage in paying bribes.

But although U.S. companies are more likely than investors from other countries to retain full ownership of firms in corrupt countries, they are not less likely than firms from other countries to undertake foreign direct investment in those countries.

This paper - a joint product of Trade and Public Economics, Development Research Group - is part of a larger effort in the group to study the effects of corruption on economic activity. The authors may be contacted at bsmarzynska@worldbank.org or swei@worldbank.org.

Suggested Citation

Wei, Shang-Jin and Javorcik, Beata Smarzynska, Corruption and the Composition of Foreign Direct Investment: Firm-Level Evidence (November 1999). Available at SSRN: https://ssrn.com/abstract=630732

Shang-Jin Wei (Contact Author)

Columbia University - Columbia Business School, Finance ( email )

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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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Beata Smarzynska Javorcik

University of Oxford - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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United Kingdom

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