DP2967 Corruption and Foreign Direct Investment: Firm-Level Evidence

Author(s): Beata Smarzynska-Javorcik , Shang-Jin Wei

Publication Date: September 2001

Keyword(s): corruption , composition of foreign direct investment , multinational firms

JEL(s): F23

Programme Areas: Transition Economics

Link to this Page: www.cepr.org/pubs/dps/DP2967.asp

This Paper studies the impact of corruption in a host country on a foreign investor’s preference for a joint venture versus a wholly owned subsidiary. A simple model highlights a basic trade-off in using local partners. On the one hand, corruption makes 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 investor’s intangible assets and lowers the probability that disputes between foreign and domestic partners will be adjudicated fairly, which reduces the value of having a local partner. The importance of protecting intangible assets increases with investor’s technological sophistication, which tilts the preference away from joint ventures in a corrupt country. Empirical tests of the hypothesis on a firm-level data set show that corruption reduces inward FDI and shifts the ownership structure towards joint ventures. Conditional on FDI taking place, an increase in corruption from the Hungarian level to that of Azerbaijan decreases the probability of a wholly-owned subsidiary by 10-20%. Technologically more advanced firms are found to be less likely to engage in joint ventures. On the other hand, US firms are found to be more averse to joint ventures in corrupt countries than investors of other nationalities. This may be due to the US Foreign Corrupt Practices Act.