Foreign direct investment, financial markets, and political corruption

The purpose of this paper is to investigate whether foreign direct investment (FDI) can stimulate financial development in countries with corrupt dominant élites. Financial markets have not been expanded in many developing countries despite their proven positive effect on economic growth. Although three voluminous and parallel lines of research investigate the impact of financial markets, FDI, and political corruption on economic growth, no research up to now has examined the combined effect of foreign investment and corruption on financial development.

To investigate the causal links, a multivariate Error Correction Model (ECM) is applied on a sample of 22 developing countries, over the period of 1976‐2003.

Overall, the study provides some preliminary evidence that FDI may jump‐start financial development in developing countries. Furthermore, the results indicate that most of the causal links are found in developing countries which experience a higher level of corruption in the form of excessive patronage, nepotism, job reservations, “favor‐for‐favors”, secret party funding, and suspiciously close ties between politics and business.

The study, however, does not provide any evidence that FDI can reduce political corruption. Much additional theoretical and empirical research is needed to explore whether FDI can influence political and economic traditions and stimulate financial markets.

The study is the first empirical attempt to examine the causal link between FDI and financial markets in interaction with political corruption.