The effect of corruption on stock market (SR) returns is heterogenous and depends on the specific institutional aspects in which it interacts. Corruption interacting with institutions generates both positive and negative returns, either greasing or adding sand in the wheels of stock markets. This heterogeneity is a consequence of the fact that institutions are multidimensional and interact differently with corruption. We provide empirical evidence for this phenomenon using monthly data on BRIC countries during 1995-2014 and focus on democratic accountability, law and order and bureaucratic quality.
We use a panel two-way fixed-effect model, where CORR is corruption, DA is democratic accountability, LO is law and order and BQ is bureaucratic quality. Our results indicate that a high level of perceived corruption reduces SR and that the interaction effect of CORR with DA and LO is negative. This is because a high level of corruption distorts the rule of law and increases red tape, which makes it difficult to start businesses and conduct business activities. It also reduces property rights, which leads to a loss of investment return.
On the other hand, a low level of perceived corruption improves SR by reducing red tape and increasing efficiency in bureaucratic processes. This improvement is most evident in the case of the defence industry, which imposes stringent requirements for companies to operate and can easily reveal bribery, kickbacks or influence peddling. Nevertheless, the defence industry is a minority player compared to other sectors in the economy. As such, the defence sector is a less attractive place for investors to put their money.