Effect of corruption distance on FDI flows to Latin America

Abstract

The aim of this research is to understand how corruption affects the attraction of Foreign Direct Investment (FDI). Studies of corruption and its relationship with FDI have yielded mixed results; some have found that corruption deters FDI others have found no relation between the two factors, while others have found a positive one. In order to further the knowledge of how corruption affects FDI this study argues that it is not only the level of corruption what might affect FDI but also the distance between host and home countries. This study presents two sections, the first one concentrates on a macroeconomic level analysis of corruption and how it affects FDI to Latin America. The second section analyses how corruption affects the decision-making process of allocating FDI to a highly corrupt host country at the firm-level.

After controlling for institutional and transaction cost variables, results show that corruption distance has an asymmetrical impact. Host countries enjoying “positive” corruption distance compared with home countries as sources of FDI experience no significant increases or reductions in levels of inward FDI. However, “negative” corruption distance suffered by host countries is associated with significantly lower levels of inward FDI. Conversely, firms from home countries with high corruption are undeterred by high corruption in host countries. This study also analysed how corruption affected foreign investors at the firm level. To do so, this study researched the decision making process of allocating FDI into a highly corrupt host country. The results of the analysis show that corruption amongst bureaucrats, judges, and members of the government elite do not seem to have an impact on the decision making process of allocating FDI in the country because foreign investors are aware of the problem. However, firms from more corrupt countries seem to have an advantage when operating in a highly corrupt foreign location because they may possess knowledge of how to cope with the arbitrariness dimension of corruption.

High corruption levels in the host country seem to have an effect on the entry mode utilised by firms from countries with lower levels of corruption. Based on the results presented on this study, MNEs from less corrupt countries might opt to enter a highly corrupt host country via wholly owned subsidiaries (WOS) rather than joint ventures (JVs). This might be explained by the fact that these investors prefer to have more control over their firms’ operations in a highly corrupt country. Also, these managers need to protect their image and not to be associated with local partners that are perceived as corrupt. Finally, even though this study found evidence that all firms operating in Guatemala might participate in corrupt deals, those headquartered in highly corrupt countries are more willing to do so. This claim is based on the fact that firms from less corrupt countries might face stronger pressures from their headquarters to not engage in corrupt deals, whereas firms from more corrupt countries might not encounter such pressures.