Corporate Corruption Matters for Public Governance:

Corporate Corruption Matters for Public Governance: Empirical Evidence and Implications for Anti-Corruption Strategies Daniel Kaufmann, World Bank Institute www.worldbank.org/wbi/governance Keynote Presentation at the 3rd ICAC Symposium on Anti-Corruption, Hong Kong, May 9 th, 2006 "If you cannot measure it, you cannot improve it." -- Lord Kelvin 1

Challenging Popular Notions on Private Sector Corruption 1. Governance & Corruption Measurement: Useless? 2. Evidence: Has Corruption declined globally? 3. Controlling of Corruption: an outcome of development? 4. Problem is solely with Public Sector/Officials in LDCs 5. Public Sector: sole shaper of the Investment Climate 6. ACCs universal approach to private sector corruption? 7. No Innovations in addressing private sector corruption 8. Investigate & Punish: the only effective tool of A-C 9. Corruption: Cultural & Historical Determinism 2

Tenet # 10: Challenging the previous 9 popular notions 1. Data Matters -- on Governance & Institutions: data can be gathered, analyzed, & used including by ACCs 2. Corruption Matters: US $1 trillion;& 300% dividend 3. Worldwide: Corruption stagnation, yet variance 4. Private Sector Corruption: Underemphasized 5. Private sector: also an Investment Climate Maker 6. Implications for institutions fighting corruption 7. Innovations: Transparency & Incentives 3 Data Partnership Illustration: ICAC World Bank Mini-Survey

Six Dimensions of Governance Governance as the set of traditions and institutions by which authority in a country is exercised -- specifically: The process by which those in authority are selected and replaced VOICE AND ACCOUNTABILITY POLITICAL STABILITY & ABSENCE OF VIOLENCE/TERRORISM The capacity of government to formulate and implement policies GOVERNMENT EFFECTIVENESS REGULATORY QUALITY The respect of citizens and state for institutions that govern interactions among them RULE OF LAW CONTROL OF CORRUPTION 4

Governance Data Data on governance from 37 different sources constructed by 31 different organizations Data sources include cross-country surveys of firms, commercial risk-rating agencies, thinktanks, government agencies, international organizations, etc. 352 proxies for all dimensions of governance Organize these measures into six clusters corresponding to definition of governance, for five periods: 1996, 1998, 2000, 2002, 2004 5

Control of Corruption: one Aggregate Indicator (selected countries from 204 worldwide, for illustration, based on 2004 research data) 2.5 Good Governance Governance Level Margins of Error 0 Poor -2.5 Governance EQUATORIAL GUINEA KOREA, NORTH TURKMENISTAN UZBEKISTAN TAJIKISTAN BANGLADESH VENEZUELA ZAMBIA RUSSIA KOREA, SOUTH MAURITIUS Source for data: : 'Governance Matters IV: Governance Indicators for 1996-2004, D. Kaufmann, A. Kraay and M. Mastruzzi, 6 (http://www.worldbank.org/wbi/governance/govdata/); Colors are assigned according to the following criteria: Dark Red, bottom 10 th percentile rank; Light Red between 10 th and 25 th ; Orange, between 25 th and 50 th ; Yellow, between 50 th and 75 th ; Light Green between 75 th and 90 th ; Dark Green above 90 th. SOUTH AFRICA GREECE ITALY BOTSWANA SLOVENIA CHILE FRANCE SPAIN UNITED KINGDOM NETHERLANDS NORWAY NEW ZEALAND FINLAND

Control of Corruption, 2004: World Map Source for data: : 'Governance Matters IV: Governance Indicators for 1996-2004, D. Kaufmann, A. Kraay and M. Mastruzzi, 7 (http://www.worldbank.org/wbi/governance/govdata/); Colors are assigned according to the following criteria: Dark Red, bottom 10 th percentile rank; Light Red between 10 th and 25 th ; Orange, between 25 th and 50 th ; Yellow, between 50 th and 75 th ; Light Green between 75 th and 90 th ; Dark Green above 90 th.

Governance Matters: The 300% Dividend 1. Large Development Dividend of Good Governance: a one-standard-deviation improvement in governance raise incomes per capita in a country by about 300% in long-run 2. But is such a decline in corruption unrealistically large?: NO -- One S.D. is the difference from: Angola Brazil Estonia or Botswana US, Canada or Germany, or, the difference from Equatorial Guinea Cuba or Uganda Mauritius Portugal Finland or New Zealand 3. The impact is from governance to incomes, and not viceversa -- higher incomes alone will not do 8

Development Dividend From Controlling Corruption $30,000 Control of Corruption $3,000 $300 Low Governance Medium Governance High Governance 9 Data Source for calculations: KK 2004. Y-axis measures predicted GDP per capita on the basis of Instrumental Variable (IV) results for each of the 3 categories. Estimations based on various authors studies, including Kaufmann and Kraay.

High Growth Competitiveness Index (EOS) 6 4 Good Governance associated Country s Competitiveness r = 0.90 CHN THA IND EGY POL MEX SLV GHA COL BGR TTO KAZ HRV PERROM TURBRA NAM AZE JAM TZA IDN RUS ARG PAN PHL DZA MAR UKR PAK MDA VNM YUG NGA VEN GEO UGA MOZ MLI MKD KEN HNDGMBIH GTM MNG NIC LKA BOL ALB DOM TJK ETH MWI ECU MDG ZWE TMP BGD CMR PRY KHM GUY BEN KGZ TCD MUS URY CRI USA SWE TWN CHE NOR JPN AUS NLD GBR KOR DEUCAN NZL QAT ARE PRT AUT MYS CHL LUX ISR IRL FRA ESP HKG KWT SVN BEL CYP MLT BHR CZE HUN LVA TUN JOR LTU SVKZAF GRC ITA BWA DNK SGP ISL FIN Low 2-1.5-1.0-0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Low KK Control of Corruption High Sources: GCI drawn from EOS firm survey, WEF 2005 117 countries; Control of Corruption from Kaufmann, Kraay 10 and Mastruzzi, Governance Matters IV: Governance Indicators for 1996-2004.

Measurable Worldwide Trends in Governance Through new method, we showed that it is possible to identify significant changes over time It is found that changes can take place in the short-term: in 6-to-8 years, some deteriorations as well as some significant improvements as well Yet the world on average has not improved Good News: Some countries are improving (while others deteriorate) in governance 11

3 High Inflation Significant Decline in Inflation Rates Worldwide TRANSITION 1.5 EMERGING (avg. in logs) Low OECD+NIC 0 1984-1988 1989-1993 1994-1998 1999-2001 12 Source: Rethinking Governance, based on calculations from WDI. Y-axis measures the log value of the average inflation for each region across each period

Quality of Infrastructure 6.5 High East Asia Industrialized OECD 4 Transition Low Emerging 1.5 1997 1998 1999 2000 2001 2002 2003 Source: EOS 1997-2003 (Quasi-balanced panel). Question 6.01: General infrastructure in your country is among the best in the world? 13

Judiciary Independence (EOS survey resuls 1998-2004) High Independence 7 4 1 No 1998 1999 2000 2001 2002 2003 2004 Independence Independencia de la Judicatura OECD East Asian NICs Latin America NON OECD 14

No Significant Trend in Control of Corruption Worldwide Averages Good 0.8 EIU PRS QLM 0.5 0.2 Poor 1996 1998 2000 2002 2004 PRS country coverage in 1996: 129, all other periods 140; QLM and EIU country coverage: 115 for all periods. 15

Control of Corruption: East Asia 2004 vs. 2000 16

The Mezzo Level of Governance Measurement Based on cross-country surveys, mainly of enterprises (such as the EOS of WEF, BEEPS/WBES of WB, etc.) Thousands of firms interviewed on a range of issues; focus on governance, specialized questions More detailed unbundling of governance and corruption phenomena than aggregate indicators Relatively broad country coverage, but less than aggregate governance indicators Measuring what is taking place De Facto matters: it uncovers stark realities masked in De Jure indicators Addresses empirically: It takes two to tango 17

On Specifics the perspective of the firm Corruption is highly detrimental for the growth and competitiveness of a dynamic private sector It takes 2 to tango : firms bribe, various patterns Unbundling Corruption: different manifestations The behavior of some Powerful Firms and MNCs 18

80 Top Constraints to Business vary across regions (responses from the Firm in EOS 2005) % firms reporting constraint among top 3: Foreign Currency Infrastructure Bureaucracy 60 Corruption Tax Regulations Inflation 40 20 0 East Asia NICs East Asia dev. South Asia Sub-saharan Africa Eastern Europe Latin America Source: EOS 2005. The question posed to the firm was: Select among the above 14 constraints the five most problematic factors for doing business in your country. Note that the overall EOS sample covers 117 countries, and in some regions particularly in the Middle East, Africa and the FSU, many countries are not surveyed. Thus, regional averages need to be interpreted with caution, since typically countries not surveyed tend to rate lower in governance than those surveyed. 19

80 Corporate Corruption, 2004 % Firms report existence of bribery (avg across types) % Firms report 'corruption' 60 40 20 0 Corporate Bribery Source: Author s calculations based on EOS 2004. Nordic Countries G-7 Southern Europe East Asia NICs Non-OECD 20

Unbundling Corruption: Different types of Bribery (responses by firms 2005) % Firm Report High Bribery (1-3) Frequency of Bribery 80 60 40 20 Bribery in: Connection to Utilities Procurement State Capture Taxation Judiciary 0 OECD East Asia NICs East Asia Sub-saharan Former Eastern Latin dev. Africa Soviet Union Europe America Source: EOS firm survey, WEF2005 117 countries. Question: In your industry, how commonly firms make undocumented 21 extra payments or bribes connected with permits / utilities / taxation / awarding of public contracts / judiciary? (common never occurs).

Multinationals Bribe Abroad? % Firms Reporting Frequent Procurement Bribery, EOS 2005 % Firms Reporting Procurement Bribery is Prevalen 100 80 60 40 20 0 Domestic Firm in OECD Country OECD Multinational in another OECD country OECD Multinational in Non-OECD country Domestic Firm in Non-OECD Country Procurement Bribery is prevalent (% Firms Report) Source: EOS, preliminary. Question: In your industry, how commonly would you estimate that firms make undocumented extra payments or bribes connected with the following: permits, public utilities, tax payments, loan applications, awarding of public 22contracts, influencing of laws, policies, regulations and decrees to favor selected business interest, and judicial decisions. Any firms reporting answers 1 through 3 were considered to be reporting at least high frequency of bribery, while answers 4 through 7 were not.

State Capture Firms shape the legal, policy and regulatory environment through illicit, non-transparent provision of private gains to public officials Examples include: private purchase of legislative votes private purchase of executive decrees private purchase of court decisions illicit political party financing Finding: Countries subject to Capture of the State (or Undue Influence) by powerful firms exhibit much lower private 23 sector growth than countries that avoid State Capture

Economic Cost of Capture for Growth 25 Firms' Output Growth (3 yrs) 20 15 10 5 0 Low capture economies Based on survey of transition economies, 2000 High capture economies 24

Addressing Capture: Economic Reform, Political Competition & Voice/Civil Liberties Matter 0.4 State Capture Index 0.3 0.2 0.1 0 Partial Civil Libs High Civil Libs Partial Advanced Slow Pace of Econ Reform Political/Civil Liberties Reforms 25

Stock Market Volatility vs. Control of Corruption High 30 RUS Stock Market Volatility 20 10 r = -0.56 NGA IDN VEN COL MEX ARG TUR BRA CHN THA PHL ZWE KOR PER LKA IND SVK EGY MAR JOR POL CZE ZAF SAU HUN MYS TWN GRC ITA CHL JPN ISR PRT ESP HKG FRA USA Low 0-1.5-1.0-0.5 0.0 0.5 1.0 1.5 2.0 Low Control of Corruption High Sources: KK 1998 and Morgan Stanley Capital International Dataset and Emerging Markets Database (1998). Stock volatility 26 defined as the standard deviation of monthly returns over December 1984 to December 1998, multiplied by 100.

Extent of Insider Trading vs. Control of Corruption High 6 r = -0.55 ZWE BGD PHL Insider Trading 4 VEN SVN TUR UKR TTO GRC NGA PAK IDN PERLKA CZE COL MUS IND ECU KEN RUS THA EGY MEX POL CMR ARG BRA VNM GHA ITA HND ROMPAN HRV LTU SVK ESP KOR UGA BWA MOZ BOL SLV HUN CHL ZMB NIC YUG TZA MKD GTM JOR MDG ZAF TWN JAM HTI GMB DOM SEN BGRMAR MYS CRI PRT LVA HKG NAM PRY MLI TUN ESTURY AGO CAN DEU CHE JPN AUT NLD ISR IRL SWE FRA MWI DZA MLT BEL ETH USA NOR AUS GBR ISL NZL LUXDNK SGP FIN Low 1-2.0-0.5 1.0 2.5 Low Control of Corruption High Source: EOS firm survey, WEF2003, and KK 2002. Question to firms on insider trading: Insider trading is not 27 common in domestic stock markets, 1=strongly disagree, 7=strongly agree.

Stock Market Volatility vs. Extent of Insider Trading High 30 RUS Stock market Volatility 20 10 DNK GBR SGP NZL AUS FIN SWE IRL DEU CAN USA JPN AUT FRA CHE NLD POL PRT HKG ESP NOR CHL ITA ISR ARG TUR BRA HUN KOR ZWE PER ZAF COL EGY JOR VEN MEX IDNCHN TWN THA GRCPHL MYS IND SVK CZE r = 0.55 0 Low 2 4 6 Low Extent of Insider Trading High Sources: EOS firm survey, WEF (1998) and Morgan Stanley Capital International Dataset and Emerging Markets Database (1998). Question for insider trading: Insider trading is not common in domestic stock markets, 1=strongly disagree, 7=strongly agree. Stock volatility defined 28 as the standard deviation of monthly returns over December 1984 to December 1998, multiplied by 100. Based on Du and Wei (2004)

Insider Trading Significantly Affects Stock Market Volatility: An Example from Du and Wei (2004) US (1) China (2) Difference (3)=(2)-(1) Insider Trading 2.62 4.62 2.00 Output Volatility 1.7% 3.0% 1.3% Increase in mkt Volatility 245 bp 103 bp More volatility effect from an in insider trading > The volatility effect from an in output volatility 29

Findings on Governance & Emerging Financial Markets Du and Wei (2004): Insider trading higher market volatility Gelos and Wei (2005) find that in opaque countries: FDI, herding intensity, &, capital flight during a crisis Wei (2000): short term flows intensity in corrupt countries Mehrez and Kaufmann (1999): financial crisis more likely in less transparent countries (liberalizing) Acemoglu & Johnson (2004): property rights institutions matter for growth, I, Financial Market Development Kaufmann, Mehrez & Schmuckler (1999): Listening to data from firms matters for predicting crises 30

Misgovernance Higher Fragility of Financial Sector Soundness of Banks vs. Control of Corruption (View of the firm, GCS 2001) 7 Soundness of Banks Average Uncontrolled Rating Predicted Controlled Value 5 Low 3 Poor Control of Corruption Average Control of Corruption Source: Global Competitiveness Survey, 2001, KK Governance Indicators Good Control of Corruption 31

General Implications -- departing from convention? Challenging popular tenets: Governance measurement skepticism challenged Beyond corruption: also governance & transparency Not only administrative corruption -- influence peddling and state capture by firms is also key Private sector not merely the investment climate taker ; while public sector not alone as investment climate maker Governance Matters for country growth prospects, and for its financial markets Capital Market Development as Disciplining for 32 Governance

Towards Larger Role of Private Sector in Anti-Corruption 1. Address Undue Influence, Monopolies & State Capture 2. Data Power, Voice & Freedom of the Press 3. Transparency Reforms--substitute to over-regulating 4. Engage Bussiness Associations & Multinationals 5. Money in Politics: Political & Campaign Finance Reform 6. Focus on Incentives & Prevention: raising the cost 7. Corporate Social Responsibility reconsidered 8. Capital Markets Development as market-disciplining 9. Addressing Financial/Banking sector challenges 10. ACCs, IFIs: To do more in engaging the Private Sector 33

Specific Innovations, Initiatives, & ACCs Data & Indicators on private sector corruption Public Delisting of Companies engaged in corruption Voluntary Disclosure Programs (VDPs) Outreach: Transparency/Integrity Standards for Firms Need to strengthen ACCs to fulfill its role: -- Independence from Political Interference -- Political Commitment to Independence, Resources -- Strengthen Investigative Functions -- Outreach, & Incentives-Based Prevention --Advocacy for key Reforms -- Legitimacy in the eyes of the corporates & citizens 34

10 Transparency Reform Components for a Scorecard 1. Public Disclosure of Assets & Incomes of Candidates, Public Officials, Politicians, Legislators - & dependents 2. Public Disclosure of Political Campaign contributions by individuals and firms, and of campaign expenditures 3. Public Disclosure of Parliamentary Votes, w/out exceptions 4. Effective Implementation of Conflict of Interest Laws, separating business, politics, legislation, & government 5. Publicly blacklisting firms bribing in public procurement 6. Effective Implementation of Freedom of Information Law, with easy access to all to government information 7. Fiscal/Financial transparency: central/local budgets; EITI 8. E*procurement: transparency (web) and competition 9. Transparent, Streamlined Regulatory Framework- 0-based 10. Corruption Diagnostic Surveys, Governance Monitoring-- Data 35

Data for Analysis and Informing Policy Advice, Not for Precise Rankings Any data on Governance, Institutions, and Investment Climate is subject to a margin of error. It is not intended for precise country rankings, but to highlight relative strengths and weaknesses and draw analytical and policy lessons. The data and indicators do not necessarily reflect official views on rankings by the World Bank or its Board of Directors. Errors are responsibility of the authors. Further materials & access to interactive data: General: www.worldbank.org/wbi/governance Data: www.worldbank.org/wbi/governance/govdata/ Governance Matters IV Report and Materials: www.worldbank.org/wbi/governance/pubs/govmatters4.html Synthesis Article about Myths on Governance in F&D: http://www.imf.org/pubs/ft/fandd/2005/09/basics.htm 36