Fortune or Evil? The Effect of Inward Foreign Direct Investment on Corruption

We analyze how one of the central drivers of globalization, foreign direct investment (FDI), relates to the prevalence of corruption. According to received wisdom, the link between globalization and corruption depends on the presence of proper political institutions and practices. We develop an alternative explanation that looks at the effect of inward FDI on host market dynamics, which in turn affect the opportunities for rent creation. We argue that, in less developed countries, FDI inflows can increase market concentration, resulting in higher rents that public officials can demand from market actors. Yet, the positive association between inward investment and corruption is mitigated in more developed economies. There, foreign entry into a market populated by productive indigenous firms promotes competition and reduces rents. This lowers opportunities for corrupt behavior. We test this nonlinear relationship between FDI and corruption in an instrumental variable two-stage least squares setting. The results indicate that FDI is indeed associated with higher levels of corruption in less developed countries, but not in developed countries. Our findings highlight the role of globalization in shaping host countries’ market dynamics, which often set the parameters of political outcomes.