Do Markets Pave the Way for Anticorruption Reforms?

In a paper I have under review, I cite an article by Jason Brennan that points to “a robust positive correlation between countries’ degree of economic freedom (as measured by the Fraser Institute’s economic freedom ratings) and countries’ lack of corruption (as measured by Transparency International’s Corruption Perceptions Index.”1

Recent studies offer further support to this correlation:

These twin policies [anticorruption reforms and high-quality market institutions] resonate with economic research revealing a mutually reinforcing feedback loop between corruption and stalled development. Corrupt officials misappropriating government money defund public goods and services, including those that might deter corruption. Bribing corrupt officials for regulatory favours or subsidies diverts corporate spending away from investing in productivity and corporate attention away from market signals. This stalls growth, and stalled growth locks in corruption (Krueger 1974, Fisman and Svensson 2007, Ayyagari et al. 2014).

Unfortunately, corruption is an enticing ‘second best’ optimal policy for key actors in an economy with an interventionist government. Bribes grease squeaky bureaucratic wheels to help businesses get things done where officials, not markets, allocate key resources. Bribes supplement officials’ incomes where stunted economic activity keeps government revenues low (Fisman 2001, Wei 2001, McMillan and Woodruff 2002, Li et al. 2008, Calomiris et al. 2010, Agarwal et al. 2015, Zeume 2016).

But once entered, this second-best thinking can entrap a whole economy in a low-level pit (e.g. Murphy et al. 1993, Morck et al. 2005). Powerful officials rationally focus on maximising bribe income (even erecting artificial regulatory barriers they can take bribes for removing), rather than institution building. Profit-maximising firms rationally invest in bribing officials because bribes, not enhancing productivity or responding to market signals, have higher returns. This explains clear empirical findings (e.g. Mauro 1995) linking worse corruption to slower growth.  

The authors note that almost “half of China’s listed firms are S[tate ]O[wned ]E[nterprise]s, and the anticorruption Policy affected SOEs and non-SOEs differently.” They continue,

In less liberalised provinces, officials still allocate key resources, so bribing them is critical to get anything done. Deprived of the ability to pay bribes, their non-SOEs might be caught in frozen bureaucratic gears (e.g. Wei 2001). Expecting this, shareholders would price non-SOEs in less liberalised provinces lower on news of the anticorruption Policy. 

In more liberalised provinces, where market forces allocate resources, officials still solicit bribes, but as fees for passing artificial ‘toll booths’ they erect in non-SOEs paths. The new Policy was designed to suppress this behaviour, freeing non-SOEs of these tollbooth fees. Expecting this, shareholders would price non-SOEs in more liberalised provinces higher on news of the anticorruption Policy.

Figure 2, based on findings in Lin et al. (2017), shows exactly this pattern across portfolios of mainland traded shares. SOE shares gain on news of the reform. Non-SOEs in economically liberalised provinces also gain, but non-SOEs in less reformed provinces drop sharply. 

With the announcement of anticorruption reforms, investors “expect[ed] curtailed corruption to advantage non-SOEs previously more encumbered by official ‘toll booths’. Their regressions also show more non-SOEs with higher productivity, more external financing needs, and greater growth potential gaining more on news of the Policy if located in more liberalised provinces.” Furthermore, “Li et al. (2017) find evidence of a shift in credit allocation towards non-SOEs and away from SOEs as the anticorruption reforms took hold. Event studies of subsequent news of follow-on provincial anticorruption policies show non-SOEs, but not SOEs, gaining more (e.g. Ding et al. 2017). These findings are readily interpretable as reinforcing Lin et al.’s findings – investors’ initial expectations about the impact of reforms on SOEs remained unchanged, but the provincial buy-ins led investors to further boost the valuations on non-SOEs in more liberalised provinces.” The authors conclude,

Reducing corruption creates more value where market reforms are already more fully implemented. If officials, rather than markets, allocate resources, bribes can be essential to grease bureaucratic gears to get anything done. Thus, non-SOEs stocks actually decline in China’s least liberalised provinces – e.g. Tibet and Tsinghai – on news of reduced expected corruption. These very real costs of reducing corruption can stymie reforms, and may explain why anticorruption reforms often have little traction in low-income countries where markets also work poorly.   

China has shown the world something interesting: prior market reforms clear away the defensible part of opposition to anticorruption reforms. Once market forces are functioning, bribe-soliciting officials become a nuisance rather than tools for getting things done. Eliminating pests is more popular than taking tools away.    

These patterns in Chinese stock price reactions to news of a genuinely unexpected and seemingly real anticorruption reform suggest the existence of a feedback loop that reform-minded leaders might activate. Market reforms clear the way for anticorruption reforms, and create an advantage for more productive market-ready private sector firms. These are the sorts of firms that are more likely to invest shareholders’ money in productivity-enhancing growth opportunities and less willing to pay bribes. As these firms grow stronger and more important, their self-interest in further market liberalisation and anticorruption reforms would lead them to support political leaders advocating further such reforms. A self-reinforcing upward spiral towards increased wealth and better institutions ensues. 

A virtuous cycle ensues – persistent anticorruption efforts encourage market-oriented behaviour, which makes anticorruption reforms more effective, which further encourages market oriented behaviour. President Xi is right to state that anticorruption reforms are the path to developing high-quality market institutions.