ECONOMIC GROWTH AND THE ASIAN PARADOX: A STUDY ON THE DIFFERENTIAL EFFECT OF CORRUPTION IN INDIA

Morgan E. Mounts

A Thesis Submitted to the University of North Carolina Wilmington in Partial Fulfillment

of the Requirements for the Degree of Master of Business Administration

Cameron School of Business

University of North Carolina Wilmington

2010

Approved by

Advisory Committee

Virginie Vial

Nathalie Lalande

Emanuelle Mebratu

L. Vince Howe Chair

Accepted by

___________________________ Dean, Graduate School

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ACKNOWLEDGMENTS

I would like to thank my family, friends, and the faculty and staff at UNCW and

Euromed-Marseille for their support during this long process. I would especially like to

recognize my best friend and IMBA colleague Debra Garretson. Debra has provided valuable

insight along with unwavering support and constant encouragement. Without her help, my thesis

would not have been possible.

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ABSTRACT

At a time when countries around the globe are facing the consequences of a financial

crisis caused by corrupt practices and poor governance, is there still a place for development

fueled by corruption? East Asia in particular, has experienced growth in relation to corruption.

However, not all countries in Asia have enjoyed the same experience as the ‘Asian Tigers’.

India, in particular has a unique relationship between corruption and economic development.

This paper examines the differential effect of corruption in India using a framework based on the

literature of the Asian Paradox. Supporting the view that corruption may fuel growth if certain

factors are present, I conclude that the combination of country size, the political economy and

the structure of corruption networks in India have restricted the level to which their economy has

been able to grow.

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TABLE OF CONTENTS

ACKNOWLEDGMENTS .............................................................................................................. ii

ABSTRACT ................................................................................................................................... iii

TABLE OF CONTENTS ............................................................................................................... iv

LIST OF TABLES ...........................................................................................................................v

LIST OF FIGURES ....................................................................................................................... vi

INTRODUCTION ...........................................................................................................................1

LITERATURE REVIEW ................................................................................................................4

Theoretical review of corruption .........................................................................................4

Macro causes of corruption ..................................................................................................8

Effects of corruption ..........................................................................................................15

The Asian Paradox .............................................................................................................17

Summary ............................................................................................................................23

A STUDY ON THE DIFFERENTIAL EFFECT OF CORRUPTION IN INDIA ........................24

Introduction ........................................................................................................................24

Methodology ......................................................................................................................26

Country Size.......................................................................................................................27

Domestic politics/Industrial Organization of Corruption ..................................................29

Corruption networks .......................................................................................................30

DISCUSSION ................................................................................................................................32

REFERENCES ..............................................................................................................................34

APPENDIX ....................................................................................................................................38

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LIST OF TABLES Table Page 1. Causes of Corruption ..................................................................................................................9

2. Historical average annual GDP growth percentages per capita .................................................18

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LIST OF FIGURES Figure Page 1. Transparency International’s Corruption Perception Index 2009 ................................................2 2. Comparison of average GDP growth per capita to corruption rankings ....................................21 3. Comparison of indicators of business environment in South and East Asia .............................25

INTRODUCTION

At a time when countries around the globe are facing the consequences of a financial

crisis caused by corrupt practices and poor governance, is there still a place for development

fueled by corruption? The neo-liberal view of corruption claims that it causes over regulation and

that it can be eradicated by open markets and free trade. Organizations, like the World Bank

support this view, often basing their assistance on the presence of good governance within a

country.

Corruption is a serious problem that can slow economic development, deter foreign direct

investment, reduce tax income, reduce efficiency in business transactions and public services,

and reduce the amount of funding available to important public programs. In this study

corruption is defined as “the use of public office for private gain” (Bardhan, 1997, p. 1321). A

worldwide movement to reduce corruption has emerged that includes participation from NGO’s,

private firms and advocacy groups.

According to Svensson (2005),“the most devastating forms of corruption include the

diversion and outright theft of funds for public programs and the damage caused by firms and

individuals that pay bribes to avoid health and safety regulations intended to benefit the public”

(Svensson, 2005, p.19). These damages particularly hurt developing economies that already lack

proper funding for public programs.

The map in Figure 1 depicts levels of corruption perceptions across the Globe; with the

most corrupt countries colored in dark blue. A majority of the highly corrupt countries are

developing or transition economies with low levels of income. Also, many of the nations have

recently been governed by socialist regimes and (besides Indonesia) have closed economies

(Svensson, 2005, p.24).

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Figure 1: Global Perceived Levels of Corruption

Source: Transparency International (2009 a)

Corruption can appear in many forms, including bribery, fraud, extortion, kickbacks and

embezzlement; depending on the context and situation. Corruption can be caused by a number of

factors. Laws, cultures and customs, weak governments, too much bureaucracy

Asia is a unique case in which some sections, East Asia in particular, has experienced

exponential growth paired with high corruption levels. However, not all countries in Asia have

enjoyed the same experience as “East Asian Tigers”. In particular developing nations, such as

India, with a weak de-centralized government have experienced the most negative impacts.

Why has India not experienced the same economic growth as other Asian countries with

high levels of corruption? India’s economic growth has suffered due to the corruption caused by

a combination of a weak government with a high level of bureaucracy and a culture of bribery.

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The differential effect of corruption, caused by the factors mentioned above, is an important area

for future research (Svensson, 2005, p. 40). Currently the research literature lacks studies that

focus solely on corruption in India.

As such the purpose of this study will be to analyze the differential effect of corruption in

India. To begin we will review the literature on the theories, causes, and effects of corruption. In

the review an emphasis is placed on empirical studies of corruption in the context of the Asian

Paradox. Next a country study on India is conducted using a framework based on factors of

corruption mentioned in the literature review. Last, there will be a discussion of findings and

conclusions.

LITERATURE REVIEW

The literature review will address three areas related to the effects of corruption on

economic growth. In the first section there will be a discussion on research related to the

theoretical study of corruption. The second section reviews empirical evidence on the causes and

effects of corruption at the macro level. Last, the third section will focus on empirical research

studies about corruption in Asia and the Asian Paradox.

Theoretical Review of Corruption

Before the empirical data regarding the economic effects of corruption can be evaluated,

one must have a thorough understanding of the theoretical concepts of corruption. Basic issues

such as defining corruption, identifying the causes of corruption, evaluating corrupt agency

relationships and analyzing the effects of institutions, culture and political economy; all

influence how researchers approach empirical research.

What is Corruption?

A popular definition for corruption, found throughout the literature, is ‘the misuse of

public office for private gain’ (Mishra, 2005, Svensson, 2005, Bardhan, 1997). The term misuse

often implies that an illegal action has occurred. But not all corrupt acts are illegal; some may

simply be dishonest or improper. While this definition is useful in the context of public

corruption, one must also recognize that corruption flows from the private sector as well. Global

firms often posses power equal to that of a public official and they can abuse that power as such.

Mishra (2005) provides a simple definition of corruption as “behavior that deviates from formal

duties because of private gains” (p. 4). This definition is more suitable to the study of private

corruption.

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It is important to note that bribery, a form of corruption, is often confused with rent

seeking. Svensson (2005) explains that “rent seeking is the socially costly pursuit of rents, often

created by governmental interventions in the economy, while bribes are technically a transfer”

(p.21).

Corruption can appear in many forms, including bribery, fraud, extortion, kickbacks and

embezzlement; depending on the context and situation. According to Shah (2007), types of

corruption typically fit into one of four categories.

1. Petty, administrative, or bureaucratic corruption. Many corrupt acts are isolated

transactions by individual public officials who abuse their office by demanding bribes

and kickbacks, diverting public funds, or awarding favors in return for personal

considerations. Such acts are often referred to as petty corruption, even though, in the

aggregate, a substantial amount of public resources may be involved.

2. Grand corruption. The theft or misuse of vast amounts of public resources by state

officials—usually members of, or people associated with, the political or administrative

elite—constitutes grand corruption.

3. State or regulatory capture and influence peddling. State capture is the collusion by

private actors with public officials or politicians for their mutual, private benefit. In this

form of corruption, the private sector “captures” the state legislative, executive, and

judicial apparatus for its own purposes. State capture coexists with the conventional (and

opposite) view of corruption, in which public officials extort or otherwise exploit the

private sector for private ends.

4. Patronage, paternalism, clientelism, and being a “team player.” Corruption occurs

when officials use their official position to provide assistance to clients or colleagues

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with the same geographic, ethnic, or cultural origin so that they receive preferential

treatment in their dealings with the public sector, including public sector employment

(pp.235-236).

Although the type of corruption may vary, it continuously stems from a common relationship:

that of the principal and the agent. Various conflicts of interest and a general imbalance of

information contribute to the inherent problems of agency relationships, which we will discuss in

the next section.

Agency Relationships

Corruption can always be traced back to the structure of a relationship between two

parties. This agency structure is a central theme in the study of corruption. Mishra (2005)

explains, “an agency relationship arises when two individuals enter a non-market (contractual)

relationship and where one individual (commonly termed as the principal) relies on another

individual (commonly referred to as the agent) to carry out certain actions on his behalf” (p.5).

An agency relationship could be something as simple as one relying on a passport official to

issue a passport timely or something more complicated like citizens relying on their government

to use public funding for its intended purpose.

The problem with agency relationships is that they are ideal situations for corruption to

occur. Bardhan (1997) states that the combination of economic and political corruption usually

“refers to the use of public office for private gains, where an official (the agent) entrusted with

carrying out a task by the public (the principal) engages in some sort of malfeasance for private

enrichment which is difficult to monitor for the principal” (p. 1321). Difficulty in monitoring,

unenforceable contracts and the difference in objectives between the principal and agent are the

main sources of problems in agency relationships.

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For corruption to truly begin, two agency relationships are needed. First, the relationship

between the principal and the agent and second an additional, more public, agency relationship.

Mishra (2005), list examples of “relationships between government and tax payers, regulator and

firm, police authority and potential criminals, government provider of services and potential

recipients” as examples of public agency relationships (p.5).

The public sector has many different types of agents that provide services like regulation

and law enforcement. They are often not under the direct supervision of the principal (the

government), but they almost always interact directly with a third party (the public). Because

the government lacks sufficient information on the actions of the public, they must act as a

principal and use an additional agent to gather information and enforce rules. The government

uses various methods to entice the agent to act honestly but due to a conflict of interests, a third

party will also attempt to entice the agent to act dishonestly.

“Corruption arises when some third person, who can benefit by the agent’s actions, seeks

to influence the agent’s decisions by offering him a monetary payment which is not passed on to

the principal” (Mishra, 2005, p.6). This three-way agency relationship fits well when describing,

for example, the relationship between a regulatory authority, inspector and a private firm. For

political corruption, the framework becomes more complicated and would need to be extended to

analyze the blurry line between political and economic corruption (Mishra, 2005, p.7 & Bardhan,

1997, p.1321).

The traditional view of distortion is when a third party bribes an agent to manipulate data

or a report in favor of the firm or individual. But distortion can come from both sides;

sometimes the firm or individual may have to bribe the inspector not to submit a false report.

When a firm must bribe and inspector even though they have broken no laws, this is called

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extortion (Mishra, 2005, p.9). The difference in the two situations is bribery to cover up wrong

doings (positive bribery) and bribery to not distort the truth. Both types of corruption lead to

“distortion of incentives” (Mishra). For example, if a firm can pay a bribe to a pollution inspector

to avoid a fine then they will be enticed to continue to pollute. Or, if a firm has to pay a fine to

the pollution inspector even though they follow the rules and meet pollution standards they might

be more prone to just start polluting since they have to pay a fine either way.

The agency model is micro-theoretic, but there are other macro perspectives that

concentrate on the more extensive socio-economic structure (Mishra, 2005, p.7). These macro

theories include “the nature and the role of formal state institutions, the divide between economic

and political sphere and the development of market and other institutions” (p.7).

When economic markets do not exist or do not function properly individuals and firms

may “attempt to escape the invisible hand of the market and to redirect policy proposals for their

own advantage” (Jain, 2001, p.87). As told by Mishra (2005), when “profit considerations find a

market in the public sphere” it reflects the traditions instilled in a society long before capitalism

took hold. Although this view may explain why corruption remains in a society who has recently

broken free from the constraints of a closed market or the burden of colonialism, it does not give

reason to why corruption persists hundreds of years later. The answer to this question can be

better explained in the macro-framework.

Macro Causes of Corruption

As mentioned in the previous section, corruption begins with an agency relationship

based on asymmetrical information and competing objectives. But the structure of institutions,

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political economy, and culture all create an environment for corruption to develop and grow

within the agency relationship.

Gurgur and Shah (2005), gathered data from the Transparency International Index and

performed a statistical regression analysis to rank the causes of corruption. Their results are

depicted in Table 1. A significant finding was that changing just one standard deviation from a

“command-and-control culture to a service oriented culture may decrease corruption by over 17

percent” (p.20).

Table 1

Causes of Corruption Based on Regression Analysis of Industrial and Non-Industrial Countries

Cause of corruption Rank of

importance

Effect of one standard deviation change

on corruption (% change around mean)

Lack of Service Orientation in

the public sector

1 17.27

Weak democratic Institutions 2 -15.54

Degree of closed economy 3 10.37

Colonial Past 4 8.23

Laxity of bureaucratic controls 5 -2.00

Centralized decision making 6 -4.20

Source: Gurgur and Shah (2005), p. 19

Gurgur and Shah (2005), also empirically analyzed, based on the Transparency

International Index, the causes of corruption in developing countries. They name the key factors

of corruption as “lack of service orientation in the public sector, weak democratic institutions

and a closed economy” (p.25). Because most developing countries have a colonial past, previous

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colonial control not make a significant impact like in the overall country analysis. The authors

also found that developing countries have more fundamental deficiencies such as lack of

democracy and weak rule of law, which must be dealt with before the structure of the economy

and decentralization can become defining factors of corruption (p.20).

Industrial Organization of Corruption Networks

In a seminal article by Shleifer and Vishny (1993), the agency theory is accepted as a

known issue and they, in turn, focus on the industrial organization structure of corruption

networks and distortionary effects of corruption versus taxation. One major finding of the study

was “weak governments that do not control their agencies experience very high corruption

levels” (p.599). Bardhan (1997) also covers this theory in his overview of corruption explaining,

“the extent of centralization in the rent-collection machinery is very important in deciding the

economic consequences of corruption. Weak and fragmented governments (even those with

authoritarian rulers) are very harmful” (p.1324).

Shleifer and Vishny (1993), explore corruption in the context of three different industrial

organization models. First, they present a simple model of corruption where a firm or individual

only requires one government good and the supply of that good is completely controlled by one

official. This monopoly model is useful in understanding the organization of corruption networks

in traditional Communist governments, monarchies and mafia-controlled regions (p. 605). In

these places knowing whom to bribe and the price of the bribe is common knowledge. In this

strict and highly controlled environment, the bribe payer feels confident that he will receive the

good requested at the agreed upon price, every time. If the government official does not

complete the transfer of goods as promised, there are strict consequences imposed by the

bureaucracy. To illustrate the situation Bardhan (1997), gives an example of Russia’s former

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Communist Party who “centralized the collection of bribes and effectively monitored (with the

help of the KGB) deviations from agreed-upon patterns of corruption” (p.1325). Set patterns of

corruption and a monitoring system provide assurance to the briber that he will receive goods as

promised and will not be required to pay further bribes. Although any form of corruption can be

detrimental to economic growth, Bardhan (1997) claims “in general centralized corruption has

less adverse consequences for efficiency than decentralized bribe taking, because in the former

case the bribee will internalize some of the distortionary effects of corruption (assuming similar

powers at all levels to determine the overall rents in the system)” (p.1324).

In the second industrial organization model of corruption, “a private agent needs several

complementary government goods to conduct business” (Shleifer & Vishny, 1993 p.604). The

agent may need several different permits and licenses to start a business and the rights to these

permits may be held by a multitude of government agents. Market structure becomes extremely

important in this situation because the government agents could choose to “collude, sell different

goods independently, or even compete in the provision of complementary government goods”

(p.605). Selling goods independently can raise the cost of bribes per unit, while competing for

the sale of the same goods may keep the bribe price down.

The third model uses the example of independent monopolists in India, some African

nations and post-Communist Russia who often sell complementary government goods in

complete disregard for the actions of other government agents. When this occurs, sellers “set

their own bribes independently in an attempt to maximize their own revenue, rather than the

combined revenue of all the bribe collectors” (Shleifer & Vishny, 1993, p.605). Bardhan (1997),

call this a “multiple veto power system…which makes centralized collection of bribes in

exchange of guaranteed favors very difficult” (p.1324). The ‘roving bandit’ theory is another

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name used to describe the independent monopolist situation. Roving bandits attempt to attain the

largest amount of bribes that they can at one time and lack regard for the sustainability of these

action in the future (Bardhan, p.1325). As a result, independent monopolists cause the “per unit

bribe to be higher and the supply of goods lower” in comparison to the collusion of joint-

monopolists (Bardhan, p.1325).

In the third model Shleifer and Vishny (1993) provide an example of competition for the

supply of government goods. When two or more government agencies can supply the same good

it gives the private firm or individual bargaining power. The authors give the example of

obtaining a U.S. passport and conclude, “because collusion between several agents is difficult,

bribe competition between the providers will drive the level of bribes down to zero” (p.607). The

opposite is true in the case of unified monopolists; they work together to maximize bribe revenue

for the group.

To conclude, there are three scenarios for the industrial organization of corruption

networks. First, a corrupt but unified administration demands bribes in exchange for providing

services one can rely on, while at the same time maximizing the total monetary value of bribes.

Second, monopoly suppliers act independently which drives down the monetary value of bribes

while increasing the frequency. Last, when there is a competitive market for government-

supplied goods or even the threat of future competition, the level of bribes will be driven down to

zero.

Institutional structure

The structure of institutions and level of centralization are connected to the organization

of corruption networks and may answer the question to why corruption is so different in each

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society. The development of the market, presence of competition, role of economic policies and

bureaucratic culture all contribute to the development of an institution.

There are two perspectives on the establishment of institutions. Svensson (2005) explains

that institutions develop as a response to economic factors. The human capital theory

compliments this view by adding that income and education also contribute to institutional

development (p.25). On the contrary, other theories argue, “institutions are persistent and

inherited” (p.26). This theory claims culture, colonization and religious beliefs all mold the way

institutions are formed and the economic response comes afterward.

Countries that are heavily controlled by the government typically have more corruption

because as bureaucratic inefficiency increases, more opportunities for government involvement

are available. Some suggest that because of overbearing government regulations, firms are forced

to participate in corruption and offer bribes so that they can complete business transactions in a

timely manner.

However a question presents it’s self: which comes first, corruption to overcome

restricting regulations and bureaucracy or corruption in the form of bureaucratic red tape?

According to Bardhan (1997), “it is usually presumed that a given set of distortions are mitigated

or circumvented by the effects of corruption; but quite often these distortions and corruption are

caused or at least preserved or aggravated by the same common factors” (p.1323). Ultimately

corruption cannot be tied just to the outside circumstances, it often a part of the institutional

structure as well. The question of which comes first, corruption or bureaucratic red tape cannot

be answered satisfactorily based on the current empirical evidence.

Increasing government wages is one suggested method of reducing corruption associated

with bureaucrat created red tap. If civil servants receive competitive salaries, based on merit and

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performance, they may be less likely to demand bribes; especially if the level of the bribes is

insignificant compared to their salary. Increased salaries may not be the solution for fragmented

institutions; Shah (2007) argues the empirical evidence for increasing civil servants pay shows

that it is not effective in countries with a weak government. Because citizens often pay bribes to

receive a job in the civil service, raising salaries will only increase the bribe paid (p.246).

Svensson (2005) agrees that in many poor emerging economies, where corruption is

institutionalized, they may not have the enforcement abilities to ensure that civil servants do not

continue to accept bribes after salary increases (p.33).

The role of civil society in reducing corruption has become a popular research topic.

Gurgur and Shah (2005), note that empirical evidence shows a high level of political and civil

rights can reduce corruption and improve governance (p.10). Committed involvement from civil

society promotes transparency in the actions of the government and it forces elected officials to

hold themselves accountable. See Sondhi (2000) for an overview on the role of civil society in

combating corruption in India.

Colonialism

In countries that were former colonies, the structure of institutions was usually designed

for the benefit of the colonizer and not the natives (Svensson, 2005, p.26). Shleifer and Vishny

“stress the identity of the colonizer and specifically the legal system transplanted from the

colonizer to the colonies. In their view, French and socialist legal origin countries (as opposed to

former English colonies) regulate more, and regulation leads to corruption” (as quoted in

Svensson, 2005, p.26). See Garretson (2009) for a review of the economic and cultural affects of

colonialism on India.

Cultural dimensions

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A culture that separates government officials from the rest of society is created when

corruption is not regulated and the value of bribes received is more than the fine for punishment

if caught. Developing countries like India, Pakistan and Indonesia, who were once ruled under a

colonial system, often have a “command and control oriented bureaucracy” that allows civil

servants to essentially be immune to public scrutiny (Gurgur and Shah, 2005, p.11). These

countries often have complicated caste systems and social hierarchies that do not require the

public sector to justify its existence to the lower castes. Gurgur and Shah (2005) explain, “people

generally view the public sector as a position to control rent sources and to exploit state authority

for personal gain” (p.11). Essentially in these nations, it is the cultural norm for citizens to accept

corruption in the government as a given and with the opinion that they are not important enough

to do anything to change it.

Effects of Corruption

Corruption not only affects the efficiency of institutions but also the economic growth of

a nation. In a review of the statistical evidence, Wei (1999) posits high corruption levels are

associated with poor economic performance. He identifies several channels through which

economic development is effected, they include: “reduced domestic investment, reduced foreign

direct investment, overblown government expenditures, distorted composition of government

expenditure away from education, health and the maintenance of infrastructure, towards less

efficient but more manipulatable public projects” (p.2).

In an influential article by Bardhan (1997), corruption is said to reduce the incentive to

invest because of the costs associated with bribes, it reduces the level of innovation in a country

and it diverts public resources away from important projects meant to enhance productivity

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(p.1328). In these examples corruption is like a secret tax that you cannot claim on your tax

return. If an entrepreneur has to pay a bribe to start a business that is not successful, the firm

cannot claim the bribe as a loss of income. Unlike taxes, bribe money does not get redistributed

to support public services. On the contrary, not only does corruption take away important

funding from public projects, it also reduces the tax base by collecting secret bribes.

Some empirical evidence supports the theory that corruption hampers economic growth.

After reviewing cross-country data from Business International, Paolo Mauro “finds a significant

negative association between the corruption index and the investment rate or the rate of growth.

A one-standard deviation improvement in the corruption index is estimated to be associated with

an increase in the investment rate by about three percent of GDP” (Bardhan, 1997, p.1328). This

negative correlation even holds true in countries where it is believed that speed money is needed

to do business.

In direct opposition with the findings above, others hypothesize that corruption may

actually improve efficiency in less developed countries that suffer from a rigid administration.

This view looks at corruption as ‘speed money’ or ‘grease’. Bardhan (1997) explains, “in the

second-best world when there are pre-existing policy induced distortions, additional distortions

in the form of black-marketeering, smuggling, etc., may actually improve welfare even when

some resources have to be spent in such activities” (p.1322). Economists who agree with this

argument explain simply that sometimes corruption is needed to grease the wheels of an over-

regulated market. They see corruption as a way to negotiate an efficient outcome in an imperfect

situation. This hypothesis assumes that the buyer has full access to the price information of the

seller.

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When the bribe payer is not aware of certain information such as “the cost levels and

bribing capacity of his competitors” it can complicate the transaction and cause information

asymmetry and inefficiency (Bardhan, 1997, p.1322). Inefficiency may result if a government

official is influenced by other considerations than just the monetary amount of the bribe.

Examples of other considerations include, “favoritism towards a particular client, or when

bribers can get away with supplying a low-quality good at a high price and when bribery is used

to limit competition from other firms” (Bardhan, pp.1322-1323). Another factor to consider is

that government officials may introduce additional administrative delays so that they can draw

more bribes.

The ‘speed money’ or ‘efficient grease’ hypothesis, as labeled by Kaufman and Wei

(1999), relies on one critical assumption that, “red tape/regulatory burden (tax, licenses, delay,

and so on) can be taken as exogenous, independent of the incentive for officials to take bribes”

(p.1). Unfortunately, corruption is often an endogenous part of the “built in corrupt practices of a

patron client political system” (Bardhan, 1997). If corrupt bureaucrats are given the chance they

will often require bribes, based on the firm’s ability to pay. In the example of endogenous

corruption, bribes are not paid to overcome a rigid administration but because of additional red

tape created by bureaucrats.

The Asian Paradox

As discussed in the previous section, the effect of corruption on economic performance is

a much-debated topic in academia. After a review of the literature, there seems to be two

schools of thought on the subject. The first claims that corruption is always detrimental to

economic performance. The second argues that in some instances corruption, although it may be

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the best worst solution, may actually have a positive effect on the economy. A special example

in which corruption does not seem to inhibit economic growth appears in studies of Asian

countries.

As a continent, Asia’s economy has grown faster than any other region in the world.

Much attention has been given to the miraculous economic growth of ten countries in the eastern

section of Asia. Sarel (1996) reports the top four performers, known as the “Tigers”, are Hong

Kong, South Korea, Singapore and Taiwan (pp.1-2). These four countries have sustained greater

than six percent annual growth rates, of output per person, for over thirty years (Sarel, 1996, p.2).

Compared to the rest of the world, where in 1990 people were 72 percent richer than in 1960, the

average Korean was at least 638 percent richer (Sarel, 1996, p.2)! China, Indonesia, Japan,

Malaysia and Thailand all sustained growth between three and five percent since 1960, followed

by the Philippines with growth of two percent a year (Sarel, 1996, p.2).

Table 2 confirms Sarel’s claims with data obtained from The World Bank’s World

Development Indicators and Global Development Finance database. Please note data for Taiwan

is not available from the World Bank; the estimation from Sarel (1996) is used instead.

Table 2

Historical Average Annual GDP Growth Percentages per Capita

Country GDP growth per capita (1961-1990)

Hong Kong 7%

South Korea 7%

Singapore 7%

Taiwan estimated at 6%, Sarel (1996)

China 5%

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Indonesia 4%

Japan 5%

Malaysia 4%

Thailand 5%

Philippines 1%

Source: The World Bank

The level of corruption in East Asia, as reported in the Transparency International’s 2008

Corruption Perception Index (CPI) (See Appendix), is high compared to the rest of the world.

The CPI rates corruption on a scale from one to ten, one being the most corrupt and the ten the

least. Any country scoring below a five has a serious corruption problem in the public sector.

In 2008, Singapore, Hong Kong and Japan rated well with scores of 9.2, 8.1 and 7.3

respectively. Taiwan, South Korea and Malaysia performed fair with scores of 5.7, 5.6 and 5.1.

China scored a 3.6, an improvement from previous years, but still disturbingly low for one of the

fastest growing countries in the world. Thailand, Indonesia and the Philippines rated even worse

with scores of 3.5, 2.6 and 2.3.

As told by Vial and Hanoteau (2010), the Asian paradox is often described as a situation

where “cronyism and corruption are prevalent, but do not necessarily hamper business” (p.693).

Or, according to Wedeman (2002), it is “the achievement of very high growth rates in real

income per capita over relatively long time periods in the face of quite high levels of corruption”

(p.34). The Asian paradox is an attempt to explain why some countries in the region have had

such rapid economic growth; it does not necessarily credit the growth to corruption, but rather

claims that it does not hinder it either.

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Rock and Bonnett (2004) claim the effect of corruption depends on the combination of:

country size, politics of corruption, industrial organization of corruption, amount of state power,

and long term strategy of corrupt officials. In an innovative study, which focused on the East

Asian Paradox, the authors performed a series of cross-country regression tests, using data sets

from four different sources. The four data sets were key because the average level of corruption

over a short time period (five years) is often very different than the average over a long period

(30 years) (p.1005). They found that after considering the above factors, “corruption tends to

slow growth in small countries in most of the developing world, but increase it in a subset of

large East Asian economies characterized by relatively stable and strong government with close

corrupt ties to big business” (p.1000).

Rock and Bonnett (2004) explain that unlike other parts of the world, there is no common

industrial organization of corruption networks in Asia (p.1003). As such, they divide the region

into three categories. Hong Kong, Singapore and Malaysia are represented as SINGHKMAL in

Figure 2. These three newly industrializing countries (NICs) have high economic growth paired

with relatively low corruption. The other East Asian NICs: China, Indonesia, Korea, Thailand

and Japan, labeled as LEANICS, have enjoyed high growth and investment coupled with high

levels of corruption. This economic environment is what is referred to as the Asian Paradox. Last

are South Asia and the Philippines; labeled as SASIAP. In these countries, high levels of

corruption appear to have impaired economic growth.

Figure 2: Comparison of Average GDP Growth Per Capita to Corruption Rankings

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Source: Rock and Bonnett (2004, p. 1001).

Note: MENA=Middle East and North Africa LAC=Latin America and the Caribbean and SSA=

sub-Saharan Africa.

Rock and Bonnett (2004) explain that Hong Kong, Singapore and Malaysia have

experienced high economic growth because they are small, self-governing countries that have

committed to operating without corruption (p.1003). While elsewhere in East Asia, high growth

and high corruption “reflects monopoly control of corruption networks by strong over centralized

states” (p.1003). Last, the poor economic performance associated with high levels of corruption

in South Asia and the Philippines is due to decentralized corruption networks laden with

independent monopolists with short-term time horizons who compete for control of the networks

(p.1011). Hence, in the presence of a powerful government that sees corruption as a long-term

strategy, countries may in fact, prosper with the help of bribe and rent payments.

In a study in collaboration with the World Bank, Wei (1999) argues, “that the evidence

shows that there is no support for the Asian exceptionalism hypothesis…among East Asian host

22

countries, foreign investors still prefer to go to less corrupt countries other things being equal”

(p.16). The most influential factor that the author suggests should be accounted for is the

availability of cheap labor in East Asian countries. Wei (1999) suggests that if this factor were

controlled, it would show that investors are against corruption in East Asian countries as well.

This theory supports the view that growth in the region is due to an accumulation of one of the

four basic factors used to produce goods and services in the economy, labor, rather than total

factor productivity.

Many studies review the effects of corruption on the overall economy. But few studies

have used micro-level evidence to evaluate the consequences of corruption at the firm or plant

level. Vial and Hanoteau (2010), conducted a unique study that uses micro-level data from the

Indonesian manufacturing industry to “asses the impact of plant-level corruption on output and

productivity growth” (p.693). The authors argue “endogenous corruption may have positive

effects on plant performance if predatory officials embrace a long-term strategy” (p.694). In

essence, if corrupt officials wish to have a long career, complimented by income from bribes that

is sustainable over time; they must be careful to demand bribes at levels firms can afford.

After testing their empirical model, Vial and Hanoteau (2010), “find that corruption,

measured as bribes and indirect tax payments, has a positive and statistically significant effect on

individual plant growth” (p.693). Given that this positive relationship persisted in Indonesia from

1975-1995 (the entire period that was measured) the evidence “suggests improvements in the

efficacy of the bribes system and a strengthening of the long-term contract between firms and the

government” (p.693). The authors stress that although firms can individually benefit from

corruption at the micro-level; overall, corruption is still detrimental to the productivity of the

entire economy and should be treated as such.

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Summary

The research literature indicates that the effect of corruption on economic growth is

determined by a number of factors that vary within regions. The research articles that were

evaluated in this section provide support for and against the existence of an Asian Paradox at the

macro and micro level. The literature is mostly limited to studies on the high performing Asian

Tigers and it rarely assesses the structure of corruption networks in historically low growth

countries such as India.

An important concept that appears throughout the literature review is that corruption can

have very different effects from country to country. Svensson (2005) calls this concept the

“differential effect of corruption” and notes that it is a key area in need of more country specific

research. For example, after India’s economy finally opened to the rest of the world it began to

grow quickly and now it is growing at the same rate as the Asian Tigers. At the same time, India

scored a 3.4 on the 2009 Corruption Perceptions Index. This raises the question, could India

grow even faster if corruption were lower? Some studies have attempted to address this question

but more research that evaluates “what context and type of corruption matters” is likely to be

more helpful the varying effects of corruption by nations (Svensson, 2005, p.40).

A STUDY ON THE DIFFERENTIAL EFFECT OF CORRUPTION IN INDIA

Introduction

India was under British colonial rule until 1947. Under colonial rule South Asian

countries increasingly became ‘plural societies’, this term implies a “fragmentation of loyalties

and, in particular, little loyalty to the community as a whole” (Myrdal, 1968, p. 51). While

western nations tend to be loyal to their nation first and self second, in South Asia loyalties lie in

less inclusive groups such as “family, caste, ethnic, religious, class or linguistic ‘communities’”

(p.51). Loyalty to these less inclusive groups encourages a distinctive type of corruption called

nepotism. A government that is characterized by favoritism can be plagued with corrupt

bureaucrats who are more devoted to promoting economic success within their small social

group rather than the country as a whole.

Between 1950 and 1990 India’s economy was completely closed, causing growth to

remain stagnate. India was second only to the Communist bloc as the most controlled economy

in the world (Lankester, 2004, p.296). Finally in 1991, their economy was liberalized. Still, it

was not until 2006 that the economy began to grow at a rate comparable to the Asian Tigers.

Lankester (2004) claims if India had pursued better policies earlier in the century it could have

enjoyed faster economic growth and more rapid reduction in poverty (p.303).

In 2008, the World Bank ranked India’s GDP at 12th in the World. Out of 183 countries,

India is ranked at 133 for overall ease of doing business compared to Singapore is who number

one. India is ranked at a horrifying 182 for enforcement of contracts, compared to China’s

ranking of 89 (World Bank, 2009). See Figure 3 for a comparison of other business indicators in

South and East Asia.

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Figure 3: Comparison of Indicators of Business Environment in South and East

Source: Devarajan & Nabi 26, p.11)

India’s economy has experienced great growth, especially in the services sector. But one

could wonder how much more India could grow without the burdens of an inefficient and corrupt

political system. In a review of data concerning the effect of a change in corruption over a

variety of indicators, Wei (1999) found “an increase in corruption reduces the quality of roads,

and increased incidence of power outages, telecommunication faults and water losses” (p.12).

Wei (1999) gives an example where if corruption in a country were raised from Singapore to

Pakistan levels, there would be fifteen percent more roads in poor condition.

The poor state of India’s infrastructure and social programs exemplifies this point. As

told by Wei (1999), “corruption tends to skew public expenditure away from health and

education, presumably because they are more difficult to manipulate for bribe purposes than are

other projects” (p.11). Although an open market, even a corrupt one, can solve many problems it

cannot mend the social ills caused by a corrupt political system.

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To reduce corruption and promote more investment, foreign and national, India needs to

“reform the government’s role in the economy, especially in areas that (by giving officials

discretionary power) are hotbeds of corruption” (Wei, 1999,p.2). Many civil workers in India

are paid a very low salary, which may entice them to engage in corrupt practices. India should

focus on “recruiting and promoting civil servants on the basis of merit and paying them a salary

competitive with similar jobs in the private sector” (Wei, 1999, p.2). Offering more competitive

pay could reduce the temptation to steal or accept bribes.

After an analysis of a data set of foreign direct investment from the early 1990s, Wei

(1999) claims, “if India could reduce its corruption level to the Singapore level, its effect on

attracting foreign investment would be the same as reducing its marginal corporate tax rate by 22

percentage points”. Many Asian countries already offer tax holidays for new investors, but

reducing corruption appears to be a more cost effective way to attract investment.

Although India is famous as a location for outsourcing, it is not producing jobs at a

sufficient rate to support the growing population (Jenkins, 2006, p.149). The coveted

information technology service jobs only make up .2 per cent of employment (Jenkins, 2006,

p.149). A democracy that cannot produce enough jobs for its people becomes a danger to its self.

If India does not find a method to control the many corruption networks within the country, the

economy could face dire consequences. Jenkins (2006) even suggests there could be a political

upheaval against open market policies if the liberalized economy does not result in more jobs.

Methodology

After reviewing the data on the Asian paradox, one is left to wonder why India has not,

until recently, experienced the same high levels of economic growth as the East Asian Tigers?

27

India’s economy has grown rapidly in recent years even with a Corruptions Perceptions Index

score of 3.4 (see Appendix). Could India be a new addition to the Asian Paradox? Or, if

corruption were reduced would India’s economy perform even better.

Rock and Bonnett (2004) introduce a compelling framework in which to analyze the

differential effect of political corruption in Asia. In their study, like in other research articles on

Asia, India was mentioned only briefly and placed into the South Asian category. India is a

unique country that is poised to overtake China as a major player in the world economy.

Although India has received much attention for their recent growth, there is still a lack of

research on the differential effect of corruption among countries and regions (Svensson, 2005).

This study will evaluate the differential effect of corruption in India with a framework

based on evidence presented by Rock and Bonnett (2004), Shleifer & Vishny (1993) and

Lankester (2004). The effects of the following factors will be analyzed: country size, domestic

politics, industrial organization of corruption and corruption networks.

Country Size

Country size is one variable to examine when considering differences in economic

performance among nations. Large countries often have extensive internal markets and plentiful

supplies of labor. Rock and Bonnett (2004) hypothesize that large nations with high populations

are better equipped to practice import substitution for longer time periods. As a result, these

nations are less reliant on foreign aid and are able to ignore pressure from the international

community to reduce corruption (p.1000). Investors are likely to overlook corruption in

exchange for unhampered access to a large pool of inexpensive labor (Rock & Bonnet, 2004,

p.1000).

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Conversely, small countries cannot sustain import substitution policies for long. If these

nations wish to grow they are forced to be more open to foreign aid and investment. The World

Bank and other NGOs often base their aid and investment under the caveat that developing

economies “conform to emerging international norms regarding governance and corruption”

(p.1000). Also, since these countries have small domestic markets and a limited supply of labor.

International firms have no incentive to overlook corruption like they do in large nations. This

combination of factors explains why small countries like Singapore, Malaysia and Hong Kong

all have low levels of corruption with high economic growth.

The effect of country size on large countries has different results depending on the

country. Rock and Bonnett (2004) list China, India, Brazil and Mexico as examples. Even though

all of these countries have huge supplies of cheap labor, they have experienced different rates of

economic growth. China has achieved high economic growth with high levels of corruption but

Mexico has the opposite outcome. India has experienced both effects. Until the late 1990s it had

high corruption and low growth but presently India has very high economic growth with

comparatively high levels of corruption.

The sheer size of India’s labor pool is very enticing to foreign investors and has been

credited to stimulating their economy. In fact, India will soon overtake China as the most

populous country (Haub & Sharma, 2006). A large supply of cheap labor alone cannot overcome

other inherent problems like a weak democracy that is segmented by many different corrupt

officials. This may be why India has experienced high economic growth but not as great as that

of China. This leads to the next section, which will examine the effect of domestic politics.

29

Domestic Politics/Industrial Organization of Corruption

The differential effect of corruption on investment and growth also depends on domestic

politics, or as others label it, the industrial organization of political regimes (Rock and Bonnett,

2004; Shleifer & Vishny, 1993; Lankester, 2004). The commitment to reduce corruption from

strong autonomous states like Hong Kong, Singapore and Malaysia, complimented by

investment from the west, has resulted in low corruption and high growth in these small

countries (Rock and Bonnett, 2004, p.1003). In the East Asian Paradox countries, high growth is

paired with high corruption a result of a “relatively stable and strong governments with close and

corrupt ties to big business” (Rock & Bonnett, 2004, p.1000).

In India’s case there is a weak democracy with “electoral politics driving the adoption of

suboptimal fiscal and micro-economic policies” the decentralized government is unable to

control corruption among their large population (Jenkins, 2006, p.148). Oppositely, in China “the

government’s freedom from the burdens of democracy… provides officials with the tools to

stamp out the most growth-retarding forms of corruption” (Jenkins, 2006, p148). Although neo-

liberals claim that an open market and democratic government will encourage growth and reduce

corruption, in India it seems that democracy actually inhibits growth.

India’s weak democracy is dominated by patron client relationships where clients

frequently extract rents in the form of favors, protection and jobs. Although some of the rents are

redistributed to the needy, overall this system is harmful to economic growth (Rock and Bonnett,

2004, p.1005.) This is because when clients have influence over public officials it reduces the

overall authority and validity of the government.

The fundamental problems discussed above could be potentially traced back to India’s

transition from colonial rule to self-governance. When a legacy of corruption is passed on to a

30

newly formed democracy the industrial organization of corruption can be significantly altered by

“exchanging monopoly control of corruption networks extant in the ancient regimes with more

decentralized corruption networks fraught with the problems associated with corruption networks

dominated by multiple independent monopolists” (Rock & Bonnett, 2004, p.1011). This shift in

organization could transform corruption from a growth enhancer to an inhibitor.

Corruption networks

In addition to the strength of the government, the organization of corruption networks is

also a factor to consider. Results depend on who controls the network: a stable group who is in

control over a long period of time or an ever changing group of politicians who try to gain as

much as possible over a short time period. According to Rock and Bonnett (2004), “when those

networks are organized by a strong centralized state, corruption is likely to be less corrosive to

investment and growth than when it is organized by numerous government officials acting as

independent monopolists” (p.1003). When a strong central government has been in power for a

long time, corruption may be more centralized and controlled. In India’s case, corruption is not

centralized and independent monopolists control most of the corruption networks (Rock &

Bonnett, 2004.)

The time horizon of monopolists in corruption networks can greatly affect the level of

bribes received and economic growth. The secret to success for the large developing countries in

East Asia is that they have a government with a monopoly control combined with a long-term

view on corruption. They have invested seriously in public goods and infrastructure, which

enables them to trade privileges for bribes that they use to assure their political power and enrich

themselves (Rock & Bonnett, 2006, p.1004). In India’s case the weak government, with many

31

corruption networks, makes it difficult to provide public services and in turn makes growth more

difficult.

A key difference in the corruption networks of India is that they are controlled by a

significant number of independent monopolists who tend to have long time horizons (Rock &

Bonnett, 2006, p.1004). These stationary bandits often make a life long career out of rent and

bribe collection. But stationary bandits are only helpful to economic growth when the

government is strong enough to control them. India is missing a key component of the Asian

paradox equation: a centralized administration who monitors and controls corruption.

After an extensive review of the literature, it is clear that there is a peculiar relationship

between economic growth and corruption in all of the Asian countries. The case of India is

interesting because they are a democratic country with a large labor pool that has experienced

tremendous economic growth, but their growth compared to strong corrupt states like communist

China is not as impressive.

Am I suggesting that India should have a more authoritative political regime? I think that

perhaps India was not ready to handle a democracy combined with the corruption level in the

country. On the other hand I do not agree that corruption alone can drive growth in an economy

such as China. I see corruption as the “best worst choice” in terms of governance. But as a

businessperson one must be realistic and hope that as a country grows economically the people

will be better able to free themselves of corruption.

DISCUSSION

Corruption is a serious problem that can slow economic development, deter foreign direct

investment, reduce tax income, reduce efficiency in business transactions and public services,

and reduce the amount of funding available to important public programs. This paper attempts to

highlight the importance of the study of corruption to development economics and the business

sector. Different theories of corruption were reviewed along with empirical research on the

causes and effects of corruption, specifically in Asia. In addition, a study of the differential effect

of corruption in India was conducted using a framework drawn from the literature review.

An important concept that appears throughout the literature review is that corruption can

have very different effects from country to country. Svensson (2005) calls this concept the

“differential effect of corruption” and notes that it is a key area in need of more country specific

research. For example, after India’s economy finally opened to the rest of the world it began to

grow quickly and now it is growing at the same rate as the Asian Tigers. At the same time, India

scored a 3.4 on the 2009 Corruption Perceptions Index. This raises the question, could India

grow even faster if corruption were lower? Some studies have attempted to address this question

but more research that evaluates “what context and type of corruption matters” is likely to be

more helpful in evaluating the varying effects of corruption by nation (Svensson, 2005, p.40).

The literature is mostly limited to studies on the high performing Asian Tigers and it rarely

assesses the structure of corruption networks in historically low growth countries such as India.

The study of India indicates that the country has a mix of growth enhancing and growth

retarding factors that contribute to the differential effect of corruption. The enhancing factors are

the large internal labor market and the long time horizon of corrupt officials. These officials

(stationary bandits) often make a life long career out of rent and bribe collection so it is in their

33

best interest to demand a sustainable level of bribes from firms. Unfortunately for India,

stationary bandits only enhance economic growth when they are part of one strong government

network that works for the enhancement of the state and not the individual. In conclusion, India

is missing a key component of the Asian paradox equation: a corruption network that is

controlled and monitored by a centralized administration that works to improve economic

development in the country.

For future research I would like to examine the effects of premature democratization on

economic growth. I wonder if there is a “best path” that a country should take from authoritative

regimes, like colonialism and communism, to democracy. Does the amount of time taken to

complete the path affect economic growth? It would be interesting to compare countries under

colonial control in Africa, to China, India and the early development of the United States.

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Appendix: Corruption Perceptions Index 2008 (Transparency International, 2009 b., pp.397-402)

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