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September 15, 2016

The (Fiscal) Benefits of Transparency

Transparency Fiscal Benefits

Posted by Ben Roseth[1] and Carlos Santiso[2]

Crime doesn’t pay, but what about corruption?

Since the 1960s, some have argued that corruption is the grease on the wheels of development. Inefficient bureaucracies need graft to help circumvent roadblocks of excessive red tape or unmotivated civil servants, increase efficiency and improve outcomes in investment and overall economic growth (see Leff 1964, Leys 1964). This line of argumentation has been pushed back with a slew of empirical research. Numerous widely cited articles now document the deleterious effects of corruption on governance and the rule of law, on economic growth and public investment, and more.  

Nevertheless, in the real world, corruption is still a scourge. Recent events in Latin America have reminded us just how harmful corruption can be. But once the tide of scandals and protests has subsided, will anyone care about corruption? As policymakers and civil servants navigate the turbulent waters of anti-corruption policy design and implementation, perhaps it is useful to focus on a timeless outcome: money. Simply put, when a country suffers from corruption, everyone pays. And when a country improves its corruption indicators, everyone stands to gain.

Who is “everyone” in this case? Taxpayers. How do they lose or gain? Through the cost of sovereign debt – borrowing costs for countries on the international bond market – and the resulting repayment obligations shouldered by taxpayers.

Let’s look at some of the empirical evidence. A series of studies (Ciocchini et al 2003; Depken et al 2007; Remolona et al 2008) show that as scores on Transparency International’s (TI’s) Corruptions Perception Index (CPI) decrease, borrowing costs increase. These studies all show direct causality between corruption risk and borrowing costs, controlling for other influences.

Ciocchini et al (2003) show that the global bond market views corruption as a serious consideration: they estimate that an improvement in the corruption score from the level of Lithuania to that of the Czech Republic, on average, lowers the bond spread (on the primary market, when initially launched) by nearly 20%. This is true even after controlling for variables, such as a series of macroeconomic indicators and political risk. ,.

Similarly, Depken et al (2007) estimate the impact of corruption on a country’s creditworthiness and argue that corruption impairs creditworthiness through its impact on the size of the formal sector of an economy. They find that creditworthiness, as measured by sovereign credit ratings, decreases with corruption. They predict that a one standard deviation decrease in corruption (measured again by TI’s CPI) improves sovereign credit ratings by almost a full rating category. On long-term foreign currency denominated debt, this translates into annual savings of roughly ten thousand US$ for every US$1 million of debt. Remolona et al (2008) show that corruption is a determinant of default risk, the key component of sovereign ratings.

Do these academic findings resonate in the private sector? Apparently so. Union Investment, a German asset management company, includes measurements of corruption perception in its credit ratings, arguing that while economic data provides an indication of a country’s ability to pay, corruption affects a country’s willingness to pay, citing a high correlation between corruption and sovereign defaults (Vargas et al 2014). They posit four effects of corruption on the cost of debt: (i) corruption fosters the growth of informal economies and therefore tax elusion and evasion, resulting in less government revenue; (ii) it increases the risk of statistical manipulation potentially masking worse-than-reported economic fundamentals; (iii) it reflects, or causes, economic mismanagement, including in the form of lack of public spending restraint; and (iv) it limits the possibility of political reforms, undermining trust in government and public support to structural reforms necessary to respond to crises. Union Investment takes these elements into consideration in their sovereign bond ratings and demonstrates that the corruption-inclusive rating can vary up to three levels up or down compared to the fundamental rating exclusive of corruption considerations (for example, from A+ to AA+ in the case of Germany and from BBB+ to BB+ in the case of Russia).

The ratings giant Moody’s also considers corruption in its assessment of sovereign risk. It uses the World Bank’s Worldwide Governance Indicators “control of corruption” composite measure as 25% of its overall measure on the quality of a country’s institutional framework, complemented by the “rule of law” (25%) and “government effectiveness” (50%) indices.

The overarching message here is that corruption directly impact sovereign ratings, and by extension, borrowing costs. Thus it seems clear that it “pays” to fight corruption and that improving transparency has tangible, long-term benefits. The takeaway for policymakers may still not be clear, because improving transparency takes time to bear fruit, longer than the countries’ political cycle. Even leaders with the best intentions, for whom furthering transparency and fighting corruption are central to their their agenda, are aware that they will bear the short term costs of transparency reforms (fiscal, political, or personal) and may not enjoy the longer-term benefits during their tenure. Focusing on sovereign debt, they will likely no longer be in office when it is time to repay bonds issued during their administration. However, this quandary – of the inter-temporal political economy of anti-corruption – is a topic for another post.

[1] Benjamin Roseth is a Modernization of the State Specialist and the research coordinator of the public sector governance group in the Institutional Capacity of the State Division at the Inter-American Development Bank.

[2] Carlos Santiso is the Division Chief for the Institutional Capacity of the State Division of the Inter-American Development Bank. He has written extensively on democracy, governance and aid. His most recent book, The Political Economy of Government Auditing, was published in 2009. 

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.

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