How confidence facilitates illegal transactions: an empirical approach - research showing how lack of investor confidence acts as a deterrent to corruption

American Journal of Economics and Sociology, The, Oct, 2002 by Dr. Johann Graf Lambsdorff

I

Introduction

SINCE CORRUPTION DOES NOT ALLOW for legal recourse, corrupt contracts are not legally enforceable. This is why corruption can go hand in hand with opportunism, reneging, and threats of denunciation (see Husted 1994; della Porta and Vanucci 1999; Rose-Ackerman 1999:91--110; Lambsdorff 2002). Corrupt deals can thus go along with low predictability for investors and the absence of confidence regarding mutual promises. There has lately been empirical support that this lack of confidence deters investors.

An important index for the predictability and confidence of corruption was published by the World Bank/University of Basel (WB/UB) in 1997 for a cross-section of countries. This data has been fruitfully employed in research. The World Bank (1997:103, 172) argues that for a given level of corruption in a sample of 39 industrial and developing countries, countries in which corruption functions more predictably have higher investment rates. This approach has been extended and further elaborated by Campos, Lien, and Pradhan (1999), who make use of the same data by the World Bank/University of Basel in a cross-section of 59 countries. While controlling for GDP per head and secondary school enrollment, the authors find that both low predictability and the overall level of corruption reduce the ratio of investment to GDP. The authors conclude that the type of corruption, apart from its level, is crucial to its economic effects. This measure of the predictability of corruption by WB/UB has also been employed by Kaufm ann and Wei (1999). The authors provide evidence that not only the level of corruption but also its predictability is a crucial determinant of the time that managers must waste negotiating with bureaucrats. Wei (1997) uses the term "arbitrariness" to address the same issue, making use of different data from the World Economic Forum. He argues that arbitrariness of corrupt transactions adversely impacts on capital inflows, providing a reason that corruption is more harmful than taxes. One conclusion for reform deriving from these results could be that in order to dampen the adverse effects of corruption, one should attempt to make it more predictable. Regulation and jurisdiction may help to enforce corrupt deals and thus reestablish investors' confidence. Whether this conclusion is sound will be discussed in this paper.

Fighting corruption and restoring investors' confidence commonly go hand in hand. But a conflict between these two goals can arise when investors themselves have been paying bribes. Here is one example from the power industry in Pakistan. During the tenure of former Prime Minister Benazir Bhutto, many private power companies were awarded contracts to sell power to the state Water and Power Development Authority. But the government's main anti-corruption arm believed that kickbacks had been paid in exchange to bureaucrats and politicians. After a change of government, this provided a reason for the new government to renegotiate the old contracts and cut the electricity rate by 30 percent. But the International Monetary Fund and the World Bank (whose loans to private power companies would sour in case of a rate cut) warned the Pakistani government that unilaterally cutting electricity rates would seriously lower investors' confidence. In order to exert pressure on the government, multilateral donors postponed loan agreements. (1)

A related example comes from Indonesia, where, due to charges of corruption, the government's utility authority PLN cancelled its contracts to obtain power from large power plants built by joint ventures with large foreign companies. In this case, relatives of Suharto had been given shares of the operations, raising suspicions of kickbacks and inflated prices for electricity. But foreign delegations of export credit insurers pressured the Indonesian government to honor the old contracts. It was argued that "[t]he future investment climate will be shaped by a long-term resolution . . . that protects the fundamental rights of investors . . . [Default] will impair Indonesia and our ability to work with you in the future."(2) In both these cases exists a conflict between fighting corruption and honoring (potentially) illegal deals. If corruption is primarily harmful because it adversely impacts on investors' confidence, reform might focus on restoring and preserving confidence, irrespective of how contracts have been arranged. Justification would be given to the described diplomatic measures and the honoring of deals, even when surrounded by allegations of corruption. In a similar vein, Murphy, Shleifer, and Vishny (19993:413) propose that, instead of paying bribes, politicians should be given a stake in the operation, because this would restore investors' confidence in politicians' credibility and lower the risk of expropriation.

But I dare to reject this proposition. As argued in Lambsdorff (2002), corruption incurs costs to private parties, not only due to the payment of bribes but also as a result of the variety of organizational problems that arise and result in large transaction costs. Legal recourse is not available to lower these transaction costs. Investors face a trade-off between incurring transaction costs and living with unpredictability. Low transaction costs for corrupt agreements will provide further incentives to engage in corruption. Likewise, if corrupt deals cannot be enforced, this itself can act as a deterrent to corruption. Under such circumstances, honoring corrupt deals is a cause of further entrenched corruption, which is likely to have various detrimental welfare effects besides destroying investors' confidence (Rose-Ackerman 1999; Lambsdorff 2001). By the same token, large transaction costs of corrupt agreements, while being troublesome to investors, can in turn help to decrease corruption. These costs may r ender a corrupt transaction too costly and thus induce potential partners of a corrupt transaction to prefer legal alternatives.