Emerging Markets Review 17 (2013) 1–13

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Emerging Markets Review

journal homepage: www.elsevier.com/locate/emr

Experience-based corporate corruption and

stock market volatility: Evidence from
emerging markets
Chi Keung Marco Lau a, Ender Demir b, Mehmet Huseyin Bilgin b,⁎
a
Northumbria University, Newcastle Upon Tyne NE1 8ST, UK
b
Istanbul Medeniyet University, D-100 Karayolu 34732, Goztepe — Kadikoy, Istanbul, Turkey

a r t i c l e i n f o a b s t r a c t

Article history: This paper reassesses how “experience-based” corporate corruption

Received 1 April 2013 affects stock market volatility in 14 emerging markets. We match the
Received in revised form 21 July 2013 World Bank enterprise-level data on bribes with a unique cross-
Accepted 29 July 2013
country macroeconomics dataset obtained from the World Bank
Available online 6 August 2013
development indicators. It is found that wider coverage of “realized”
corporate corruption in the emerging markets investigated reduces the
JEL classification:
stock market volatility, attributed to decrease in uncertainty about
D73
G10
government policy with regard to the business environment, as implied
G15 by the general equilibrium model of Pastor and Veronesi (2012).
G32 Overall, our results suggest that stock price volatility decreases as the
uncertainty about government policy becomes more predictable,
Keywords:
Stock market volatility which is consistent with the testable hypotheses of Pastor and Veronesi
Corruption (2012).
Emerging markets © 2013 Elsevier B.V. All rights reserved.
Uncertainty

1. Introduction

Stock market facilitates and therefore promotes capital formation, and therefore promotes economic
growth through encouraging saving and real investment. For financial markets with risk-adverse
investors, less saving and investment will be realized if the underlining stock market is too volatile, and
this is the usual implication of general equilibrium model with a representative agent maximizing utility
under uncertainty (Du and Wei, 2004). As a stylized fact, the volatility of stock market price index across
different countries can vary enormously. The volatility of stock returns is higher in emerging markets; for

⁎ Corresponding author. Tel.: +90 212 220 5451; fax: +90 212 220 5452.
E-mail addresses: chi.lau@northumbria.ac.uk (C.K.M. Lau), edemir81@yahoo.com (E. Demir), bilginmh@gmail.com (M.H. Bilgin).

1566-0141/$ – see front matter © 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.ememar.2013.07.002
2 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13

example the volatility of stock market in Taiwan in 2006 is 1.19, as measured by the standard deviation of
the daily stock price returns, which is higher than that of Hong Kong of 0.92. This figure also varies within
emerging economies: Brazil and Chile are the emerging markets with modest market liquidity (over 23%
in 2012), while the volatility of Brazil is 0.6% higher than that of Chile in 2012. Moreover, the volatility also
varies substantially across time periods. The stock market volatility for Chile in 2012 is 100% less than that
of the year in 2008, when financial crisis was prevailing.
One important source of stock market volatility comes from “government policy uncertainty”, as
argued by Pastor and Veronesi (2012). The main purpose of this paper is to assess the role of “corporate
bribery” to public officials, as a way of reducing government policy uncertainty in explaining the
difference in market volatility across countries, along with other detrimental factors like the volatility of
fundamentals and the maturity of the stock markets. To the best of our knowledge, this has not been
studied on a systematic way. A similar vein of research is the examination of the effects of corruption on
financial market volatility by Zhang (2012). The author finds evidence of correlations of corruption with
financial market stability.
However, the measure of corruption was obtained from the Corruption Perception Index 2007 and the
Index of Economic Freedom 2007 leading to an unreliable conclusion of this study. It is well known that
corruption perception index cannot be used to compare the degree of corruption across countries,
attributed to the response scale bias for corruption perception index. Leon et al. (2012) argue that
corruption perception index is problematic as a variable to measure of the corruption levels across
countries and it will subsequently lead to a misleading conclusion regarding the relationship between
corruption and financial market stability. According to Fan et al. (2009), the previous literatures widely
use perception-based corruption indexes that complied from aggregated perceptions of businessmen or
country experts. It is problematic in the sense that the rankings of corruption index are perhaps, based on
common press depictions of countries or conventional notions about what institutions or cultures are
conducive to corruption. As explained by the authors, there is a great variation when we compared the
subjective corruption indexes of Transparency International, the World Bank, and the International
Country Risk Guide to the level of reported experience with corruption.1 Recognizing the pitfall of using
these perception-based corruption indexes, the authors use an alternative measure of corruption in their
study, which is experience-based.2 The experience-based corruption measure has been used in several
studies, including a study on the telecom sector: Berg et al. (2012) use the same experience-based
corporate bribery measurement and they find that stricter regulatory policy on the telecom sector
increases firm's accountability and therefore reduces illegal bribery. Another study seeks to explain
corporate corruption using political decentralization as an influential factor. Fan et al. (2009) find evidence
that in countries with a larger number of administrative tiers, the reported bribery was more frequent in
that business environments.
While the previous studies examine the impact of political events, which only impose risk indirectly on
the market and have potential to affect market volatility, our paper differs in several critical ways. Unlike
the radical events such as political unrest or presidential election, which occurs on every 3–5 years, used
to quantify political uncertainty; we use corruption perception to measure uncertainty. There are several
advantages to model the effect of policy uncertainty on stock market volatility by using corporate
corruption instead of political unrests like civil war in Syria. First, small sample bias is a concern because
usually financial markets are absent in countries where political unrest occurs. Second, presidential
election may have an effect on stock market election in a developed market; however, monetary policies
and fiscal policies sometimes may be changed by the prevailing government to boost employment and
stock market before election. More importantly, unlike civil war or presidential elections, we need to
search for a variable that the uncertainty of stakeholders in the stock market can be better modeled. For

1
As an example quoted by the authors, Argentina and Macedonia were both rated about equally corrupt in 2000: they were
ranked 103 and 114 respectively out of 185 countries, according to the World Bank perceived corruption index. However, it was
found that when the respondents were surveyed by the United Nations Interregional Crime and Justice Research Institute (UNICRI)
in the late 1990s about their own personal experience with bribery, the result was completely different.
2
The authors use a large scale of an experience-based survey of business managers conducted in 80 countries. The World Business
Environment Survey interviewed managers from more than 9000 firms in 1999–2000. Respondents were asked: “Is it common for
firms in your line of business to have to pay some irregular “additional payments” to get things done?”
 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13 3

the above purpose corporate corruption is a natural candidate to be that variable to proxy the uncertainty
of firms evolving in the business environment.
Compared to other measures, corporate corruption has a continuous and substantial impact on the
operations of firms. Although it is widely documented that government corruption may negatively affect
the performance of firms (Getz and Volkema, 2001), Galang (2012) argues that the impact of corruption
on an individual firm's performance is heterogeneous and determined by the characteristics, capabilities,
and motivations of firms. Zhou and Peng (2012) discuss that bribery may either grease the wheel of
commerce or sand the wheel of growth. This impact (either positive or negative) of bribery will depend on
the size of the firms. By using a data of 2686 firms from 48 countries, it is found that bribery (measured by
the percentage of sales used as bribery payments to government officials) has a significant negative effect
on firm growth for small and medium-sized firms. For large firms, there is no evidence of a negative effect
of bribery on firm growth. When compared to the unlisted firms, the listed firms in emerging markets are
considered less likely to be hit by the corruption due to their connections with government officials, size,
and larger financial sources. Moreover, they can benefit from those relations and financial sources which
may lead to decrease in uncertainty about government policy regarding to the business environment. The
data we used is not based on the press depiction of corruption or political unrest, instead we use survey
responses of businessmen (Enterprise Survey of World Bank) in particular countries about their own
concrete experiences with corrupt officials and their own perception about political instability concerning
the business environment.
To the best of our knowledge, this paper is the first study on the impact of corruption except Zhang
(2012) in which the variable of corruption is problematic and the model lacks important control variables.
We investigate the role of corruption in explaining cross-country differences in 14 emerging stock market
volatility3 with a time period span from 2006 to 2012. We use a new measure of corruption in the business
environment for 14 emerging economies that is collected by the World Bank; as a common form of
expropriation risk from the government that has direct impact on a firm's interest, and therefore on stock
market volatility. The empirical evidence shows that countries with higher corrupted business
environment do have less volatile stock markets, even after controlling liquidity and maturity of the
markets, firm characteristics, and macroeconomic policy variables.
The rest of the paper is organized as follows: Section 2 provides a literature review. Section 3 briefly
describes the data. Section 4 presents the methodology while Section 5 discusses the findings. Section 6
provides a summary and concludes the paper.

2. Literature review

Prior studies document that political uncertainty and news influence the stock market volatility
(Fernandez, 2007; Goodell and Vahamaa, 2013; Onder and Simga-Mugan, 2006). The index data of the
Heritage Foundation provides an overall or a macro picture about the market condition; for example, the
“index of economic freedom” was designed to measure “basic institutions that protect the liberty of individuals
to pursue their own economic interests result in greater prosperity for the larger society”. However, when we
look at how the index is constructed — 10 economic factors are averaged equally into a total score, and
freedom from corruption is only one of the factors. It is not clear which expert and what criteria are based
when assigning the scores to each country. The Euromoney country risk index is another popular survey
which includes bank stability, monetary policy/currency stability, corruption and institutional risk. In their
official web site, they explained that the index is based on “consensus survey of expert opinion of country risk”.
In spite of the deficiencies of the above mentioned indexes we admit that every economic indicator is not
perfect. However, macroeconomics studies, for instance: the determinants of GDP may be more appropriate
to adopt those indexes. On the other hand studies on market-oriented topics, we may prefer to use
market-oriented survey from managers of the enterprises instead of “expert opinions.
The existing literature widely focuses on the impact of uncertainty associated with the elections and
political changes on financial markets. Bialkowski et al. (2008) for a sample of 27 OECD countries and

3
Emerging stock markets in our sample include: Argentina, Bangladesh, Brazil, Chile, Croatia, Czech Republic, Ecuador, Estonia,
Indonesia, Jamaica, Mexico, Peru, Philippines, and Poland.
4 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13

Boutchkova et al. (2011) for 50 developed and developing countries, examine stock market volatility
around national elections and find that volatility is significantly higher in the election periods. Moreover,
Boutchkova et al. (2011) find evidence that industries with higher political risk (i.e. industries that are
more export-oriented and outsourcing-oriented) show higher return volatility. Using a “probit” model,
Mei and Guo (2004) concentrate on the political uncertainty associated with national election; they find
evidence that increased market volatility is phenomenal during national election. In addition, there is a
significant relationship between political election cycles and financial crises. Fuss and Bechtel (2008) and
Leblang and Mukherjee (2005) also provide supportive evidence in regard to this argument. In addition to
elections, political uncertainty can take various forms such as civil war, strikes, and change of government
policy. Voth (2002) concludes that one source of stock market volatility comes from political uncertainty
regarding political unrest, demonstrations, and other indicators of instability in the interwar period.
Bittlingmayer (1998) shows that large stock market changes occur after sudden specific political
developments. Nippani and Medlin (2002), Li and Born (2006), and Goodell and Bodey (2012) also
provide supportive evidence on the effects of US presidential elections on stock markets.
Another source of uncertainty is corruption. While many empirical studies investigate the relation
between economic growth and corruption at the country level, only few have looked at the effects of
corruption on the economic performance of firms (Gaviria, 2002). The firm-level studies are scarce due to
the lack of firm-level bribery data. There are two competing approaches on how the bribery may affect the
firm's performance: Bribery greases the wheel of commerce and bribery sands the wheel of commerce
(Zhou and Peng, 2012). According to the former view, bribery helps firms to overcome the inefficiencies in
the economic system and decreases the uncertainty, which may lead to a positive performance. The latter
view argues that high costs of corruption lower the firm performance. The literature documents findings
are in favor of both views but mostly for the negative impact of corruption on firm performance. One of the
first micro-level studies on the impact of corruption on firm performance was conducted by Gaviria
(2002). It is shown that corruption has a negative impact on the economic outcomes of firms (sales,
investment, and employment). Fisman and Svensson (2007) find that there is a (weak) negative
relationship between bribery and firm growth over the period of 1995 to 1997. Likewise, De Rosa et al.
(2010) show that corruption has a negative effect on firm productivity in Central and Eastern European
countries. This means that bribe paying firms have a lower productivity compared to non-paying firms.
McArthur and Teal (2002) also provide support evidence for the negative impact of corruption on firm
performance in Africa. Anos-Casero and Udomsaph (2009), with large dataset of 22,004 firms in eight
economies of Eastern Europe and the former Soviet Union, find that one standard deviation in governance
variable (including both bribe level, tax compliance, and confidence in legal system) raises the total factor
productivity of the average firm by 3.2%. There are also a few studies which document the positive impact
of corruption on firm performance. Peng and Luo (2000) argue that personal ties with government officials
can decrease the uncertainty in business environment, which may positively affect the firm performance.
Considering the power possessed by the officials in a transition economy (namely China), it is found that good
connections with them have an important effect on market share and financial performance of firms.4
Likewise, for firms in Central and Eastern Europe, Hellman et al. (2003) show that corruption brings short
term performance advantages. Vial and Hanoteau (2010) find that corruption has a positive and statistically
significant effect on output and productivity growth in Indonesian manufacturing industry. According to
Wang and You (2012), corruption is likely to increase firm growth when financial markets are
underdeveloped whereas corruption deters firm growth when there are more developed financial markets.
There is a substitution relationship between corruption and financial development on firm growth.
Although there is a scarce literature on how the corruption may affect the firm performance, there is
almost no study on how the corruption may affect the stock market volatility. If the investors consider
bribery as a resource for firms, which decreases the uncertainty about government policies (Pastor and
Veronesi, 2012) and helps to overcome the inefficiencies in the country, bribery may lower the stock
market volatility especially in emerging markets. On the contrary, if it is considered as additional costs (or
an involuntary tax) higher levels of bribery may lead to an increase in stock market volatility. Pastor and
Veronesi (2012) conclude from their general equilibrium model that stock price volatility increases as the

4
Park and Luo (2001) also find that good connections with government authorities positively affect sales growth in China.
 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13 5

uncertainty about government policy becomes more unpredictable. By using the technique of general
equilibrium model and numerical simulation, the authors conclude that the expected dynamics of
profitability around policy changes depend on policy uncertainty.
Stock prices fluctuate (i.e. stock price volatility) as investors change their minds about what the
government is going to do. As shown by the authors, the policy uncertainty increases the variance of stock
returns as well as the volatility of the stochastic discount factor (SDF).5 Recently, Zhang (2012) finds
evidence of correlations of corruption with financial market stability by using financial data of 29
countries' index funds for the time period of 2002 to 2007. Unfortunately, the measure of corruption was
obtained from the Corruption Perception Index 2007 and the Index of Economic Freedom 2007, leading to
unreliable conclusion of this study. Moreover, the analysis does not include any economic control
variables. It is well known that corruption perception index cannot be used to compare the degree of
corruption across countries, attributed to the response scale bias for corruption perception index. Leon et
al. (2012) argue that corruption perception index is problematic as a variable to measure the corruption
levels across countries and it will subsequently lead to a misleading conclusion regarding the relationship
between corruption and financial market stability.
Another fallacy about the argument of higher corruption index (as a proxy to measure political risk)
that leads to higher volatility is the nature of volatility. Indeed return volatility can be divided into two
types, largely depending on the country's characteristics (sometimes difficult to observe); therefore, panel
regression can better capture unobserved country specific factors. As noted by Bartram et al. (2012),
return volatility can be good or bad, depending on country-specific characteristics. For example, return
characteristic can be higher in a country with better institutions (e.g. well established intellectual property
right and less corrupted court system). Firms in this country are more willing to take extra risk to invest on
research and development because the patents can be better protected. In this sense, it is possible to
observe a less corrupted market indeed to be more volatile.
On the other hand, bad volatility (such as political risk, corruption, and civil war) may dominate the
stock market, and investors do not have incentive to invest. Fan et al. (2009) argue that in the previous
literatures, perception-based corruption indexes that complied from aggregated perceptions of
businessmen or country experts are widely used. It is problematic in the sense that the rankings of
corruption index are perhaps, based on common press depictions of countries or conventional notions
about what institutions or cultures are conducive to corruption. Recognizing the pitfall of using these
perception-based corruption indexes, the authors use an alternative measure of corruption in their study,
which is experience-based. Jayasuriya (2005) explains post-liberalization volatility by considering market
characteristics and quality of institutions. Countries are categorized as countries experiencing a significant
decrease and countries experiencing a significant increase. According to this categorization, it is found that
lower levels of corruption lead to a decrease in volatility.
Chiou et al. (2010) explore how the legal environment affects risk and performance of stocks across
different countries. By using a composite index for the year 2000 that draws on fourteen data sources from
seven institutions to measure corruption, it is shown that low corruption is associated with lower stock
market volatility. Corruption also affects the costs of government borrowing. Ciocchini et al. (2003) by
using corruption data of Transparency International show that more corrupt countries pay a higher risk
premium when issuing bonds.
In developed economies like the UK, corporate bribery is not that obvious as in the emerging markets.
However, senior officials in the banking sector may take advantage of some loose procedures such that
growth in sales and revenues of the bank could eventually lead to higher income or bonus. Some banks
intend to inflating or deflating their rates to make profit from trades, or pretend to be more creditworthy.
This firm's strategy of manipulating LIBOR is later known as LIBOR scandal, and it is the senior banks'
strategy to increase their own income by improving the bank's profitability. This misbehavior also
indirectly manipulates US derivatives markets. Therefore the Parliamentary Commission on Banking
Standards in the UK published several recommendations to make senior bankers personally more
responsible and to reinforce the powers of regulators.

5
Details can be found from Eqs. (34), (35), and (41) from Pastor and Veronesi (2012).
6 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13

3. Data and methodology

We now turn to the empirical parts; we focus on panel regression analysis. Let Vt(k) be the volatility of
stock returns for country k, at time t — measured by the standard deviation of the monthly returns. Our
model specification is the following:

Vt ðkÞ ¼ α þ β1 Ft ðkÞ þ β2 Lt ðkÞ þ β3 Mt ðkÞ þ β4 Ct ðkÞ þ εt ðkÞ

where Ft(k) is a vector of variables measuring economic variables; Lt(k) is a vector for liquidity of the
market; Mt(k) is a vector for maturity of the market; and finally, Ct(k) is the variable that denotes the
corruption. α, β1, β2, β3, and β4 are the parameters to be estimated (with appropriate dimensions). And
εt(k) is a random variable that is assumed to be normally distributed with zero mean and a constant
variance.

3.1. Dependent variable

The stock return volatility is defined as the standard deviation of monthly returns for seven years rolling
over a 10 year period, from January 1996 to December 2012, multiplied by 100. For example, Argentina
(e.g. Merval Index) has seven observations on the volatility of stock returns. The first volatility observation
is for year 2006, which is computed from the raw data of the Merval Index spanning from January 1996 to
December 2006. While the second volatility observation is for year 2007, which is computed from the raw
data of the Merval Index spanning from January 1997 to December 2007. The monthly return in US Dollar
is defined as the change in the log of the stock market index (in dollar terms). Suppose Pt-1 and Pt denotes
the values of the stock market index in month t-1 and t, respectively. The return in period t, Rt =
log(Pt) − log(Pt-1). The US Dollar denominated stock market price index data for emerging stock markets
comes mainly from the Wharton Research Database (WRDS).
Our paper follows existing literature where studies use US$ returns as the variable in interest based on
the international CAPM: Abbas et al. (2013) examine the stock market volatility transmission among
regional equity markets of Pakistan, China, India, and Sri Lanka. They find evidence of volatility
transmission between friendly countries, as well as unfriendly countries. Recently Arouri et al. (2012)
propose a testable ICAPM for partially segmented markets, and the authors find that most emerging
markets become more integrated while it showed that local risk premium has been decreasing over time.
Consistent with the current literature, Arouri et al. (2013) conclude that emerging markets have become
more integrated in recent years due to waves of liberalization and reforms, leaving the degree of the risk
premium related to global factors declined.
We include all countries for which we also have data on corporate corruption measures, matching with
the World Bank Business Enterprise Survey (WBBES).6 The 14 countries covered are Argentina,
Bangladesh, Brazil, Chile, Croatia, Czech Republic, Ecuador, Estonia, Indonesia, Jamaica, Mexico, Peru,
Philippines, and Poland. In our sample, the most volatile markets are Chile and Argentina, while the most
stable ones are Jamaica and Ecuador.

3.2. Independent variables

3.2.1. Corporate corruption measure

The variable that we use for the corporate corruption measure is from Enterprise Survey of World Bank.
It is the “percentage of informal payments to public officials”. Informal payments to public officials are the
percentage of firms expected to make informal payments to public officials to “get things done” with
regard to customs, taxes, licenses, regulations, services, and the like. The regression coefficients can be
interpreted as the effect (measured as percentage change) of an increase in 1% of firms who paid informal
payment on the stock market volatility. Indeed several World Bank studies use this corporate corruption
indicator as the variable of interest. Hellman et al. (2003) find that capture economies occurred in many

6
For more information on the survey, see http://www.ifc.org/ifcext/economics.nsf/Content/ic-wbes.
 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13 7

transitional markets, where rent-generating advantage is sold by the public officials to large private
companies with strong ties to the government. Using the same set of corporate corruption data from year
2000, Martin et al. (2007) investigate the reasons why firms are choosing bribes as a strategy, and they
find that cultural and institutional drivers of firm-level bribery are important considerations when firm
makes bribes as the firms' strategy. Moreover, Fisman and Svensson (2007) use the same dataset that finds
both bribery payments and taxes harmful to firm growth.

3.2.2. Economic variables

Volatility of real GDP growth rate is computed as the standard deviation of the annual real GDP growth
rate over 1985 to 1998, multiplied by 100. Real GDP growth rate is the first difference in the log of GDP in
1995 constant US Dollar. The data are obtained from the World Bank's World Development Indicators.
The volatility of the inflation rate is the standard deviation of the inflation rate over 1996 to 2012. For
example, Argentina has seven observations on the volatility of inflation. The first volatility observation is
for year 2006, which is computed from the raw data of the inflation rate of 1996 to 2006. Inflation data is
defined as the change in the log consumer price index, which is obtained from the World Bank's World
Development Indicators.
The volatility of the real interest rate is the standard deviation of the real interest rate from 1996 to 2012.
The real interest rate is defined as the nominal interest rate minus the monthly inflation rate. Data are
obtained from the World Bank's World Development Indicators.
The exchange rate volatility is measured as the standard deviation of the change in log nominal
exchange rate with respect to US Dollar, multiplied by 100. The period covered is 1996 to 2012. Data are
obtained from the World Bank's World Development Indicators.
Trade openness is the average value of (imports value + exports value) / GDP over the period of 1996
to 2012.

3.2.3. Market liquidity and maturity variables

Du and Wei (2004) argue that less matured or less liquid stock markets may be more volatile. In line
with Du and Wei (2004), we measure the liquidity of the market by the ratio of stock market turnover to
GDP ratio. For the market maturity, we use GDP per capita that is measured in 1995 constant US Dollar for
the years of 2006 to 2012, taken from the World Bank's World Development Indicator. Number of listed
company variable is computed as the number of listed companies, obtained from the same data source.

3.2.4. Firm characteristic variables

The control variables for firm's characteristics include the following; a dummy variable to represent that
the firm is owned by foreigners (takes value of 1); percentage of sales are indirectly exported to overseas
market; firm size in terms of the number of employees; proportion of the establishment's working
capital that was financed from private commercial banks; and the variable of court fairness. The
responses came from the question: “The court system is fair, impartial and uncorrupted”, 1 = strongly
disagree, 4 = strongly agree.
The summary of the list of variables and summary statistics are presented in Tables 1 and 2,
respectively. Table 2 provides brief descriptions of the stock price volatilities and other variables across
countries. Regarding volatility (ranging from 0.3% to 13% on average), we can see from the figures that the
volatility of monetary variables (stock returns, inflation, exchange rate, and real interest rate) is more
volatile than that of the economic fundamental variable of real GDP. Technological progress and
institutional change occur gradually, and therefore the volatility of real GDP is relatively stable.
In contrast, monetary policy uncertainty is highly unpredictable because they are easily manipulated
by the central bank to serve various governments' economic and political goals. Our data is comparable to
that of Du and Wei (2004), where the authors also find the same data characteristics over the volatility of
the above variables. On average 24% of sales are indirectly exported to overseas market, while 26% of firms
are owned by foreigners. In addition, the majority of the respondents disagree with the statement that
“The court system is fair, impartial and uncorrupted”, whereby 45% of firms have to pay bribery to public
officials to get things done. Not surprisingly, there are only 2% of firms that are able or willing to get access
to loans from private commercial banks.
8 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13

Table 1
List of variables.

Variable Description Original source

The stock return volatility
Real GDP growth volatility
Volatility of inflation rate
Volatility of real interest rate Standard deviation of the real interest rate from
Exchange rate volatility
(Export + import) / GDP (%) Average value of (imports value + exports value) / GDP
Log of GDP per capita
Stock traded / GDP (%)
Number of listed companies
Firm's bribes (% of firms)
Foreign ownership
Indirect exporting firm
Firm size
Finance access to commercial
banks
Fairness of court system
and corruption
Standard deviation of monthly returns
Standard deviation of the annual real GDP
growth rate
Standard deviation of the inflation rate over
1996 to 2012
1996 to 2012
Standard deviation of the change in log nominal
exchange rate with respect to US Dollar, multiplied
by 100
over the period of 1996 to 2012.
GDP per capita measured in 1995 constant US
Dollar for years 2006 to 2012, taking natural log
Percentage of stock value traded as compared to GDP
The number of listed companies
“Percentage of informal payments to public officials”
A dummy variable to represent the firm is owned
by foreigners (takes value of 1).
Percentage of sales are indirectly exported to
overseas market
Firm size in terms of the number of employees
Proportion of this establishment's working capital
that was financed from private commercial banks
The responses came from the question: “The court
system is fair, impartial and uncorrupted”,
1 = strongly disagree, 4 = strongly agree.
Wharton Research Database (WRDS)
World Bank's World Development
Indicator
World Bank's World Development
Indicator
World Bank's World Development
Indicator
World Bank's World Development
Indicator
World Bank's World Development
Indicator
World Bank's World Development
Indicator
World Bank's World Development
Indicator
World Bank's World Development
Indicator
World Bank Business Enterprise Survey
(WBBES)
World Bank Business Enterprise Survey
(WBBES)
World Bank Business Enterprise Survey
(WBBES)
World Bank Business Enterprise Survey
(WBBES)
World Bank Business Enterprise Survey
(WBBES)
World Bank Business Enterprise Survey
(WBBES)

4. Findings

The regression estimates are presented in Table 3 (for random effects estimates) and Table 4 (for
Arellano–Bond estimator). First we consider the random effects model. The random effects estimator
assumes that intercepts are uncorrelated with the regressors. To test if the average of the fixed and
between estimates is the same as the random effects estimate, we use a Hausman test. The Hausman test is
essentially testing whether estimates for the fixed effect model are the same for the between effect model.
We therefore perform a Hausman test to test whether the individual effects are random. The null
hypothesis is that both fixed and random effects are consistent; the alternative hypothesis is that random
effects are not consistent. The result indicates that the random effects model should be used (the null
hypothesis was accepted with a p-value of 0.271), so the random effects estimates are consistent.
In our model, we consider consistent estimators of the variance–covariance of the estimator (VCE) when
the errors are heteroskedastic and when the errors are serially correlated. Without this model specification,
several economic fundamental variables and monetary policy variables exhibit misleading estimates
significance. In this sense, our model is more robust as compared to the results of Du and Wei (2004), since
their models ignore the potential existence of heteroskedasticity and unobserved characteristics among
countries.
Interestingly our results are different from that of Du and Wei (2004) regarding the effects of economic
fundamental variables and monetary policy variables on stock price volatility, possibly due to the above
mentioned modeling issues, as well as the economic constraints that have changed since year 2000, where
the data of Du and Wei (2004) only covered the period of 1984–1998. The effects on the convergence of
international accounting conventions on corporate governance have been mixed. Karamanou and Nishiotis
 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13 9

Table 2
Summary statistics.

Name of variables Number of obs. Mean Standard deviation Min. Max.

Stock market volatility 103 2.66 0.65 1.34 4.77

Real GDP growth volatility 103 0.28 0.19 0.02 0.77
Volatility of inflation rate 103 5.54 10.41 1.23 73.02
Volatility of real interest rate 103 5.75 5.75 0.53 38.33
(Export + Import) / GDP (%) 103 78.09 36.02 22.12 97.08
Firm's bribes to government officials (% of firms) 103 45.39 38.61 3.70 93.13
Exchange rate volatility 103 13.18 12.75 0.02 71.88
Log of GDP per capita 103 8.07 0.88 6.13 9.36
Stock traded / GDP (%) 103 10.90 10.80 0.16 44.03
Number of listed companies 89 246.19 153.57 16.00 757.00
Foreign ownership 103 0.26 0.73 0.03 4.38
Indirect exporting firm 103 0.24 0.09 0.10 0.41
Firm size 103 15.73 4.68 0.05 21.19
Finance access to commercial banks 103 2.42 3.72 0.61 17.88
Fairness of court system and corruption 103 1.45 0.57 −0.08 2.38

Table 3
Stock market volatility and corporate corruption (random effect).

(1) (2) (3) (4)

RE RE RE RE

Real GDP growth volatility −1.056 −2.376 −0.100 −0.780

(−1.59) (−1.58) (−0.13) (−0.75)
Volatility of inflation rate −0.0436⁎⁎⁎ −0.0767⁎⁎⁎ −0.0380⁎⁎ −0.0350⁎⁎⁎
(−2.60) (−3.11) (−2.38) (−2.68)
Volatility of real interest rate 0.0390 0.0900⁎⁎ 0.0556 0.0498
(1.22) (2.13) (1.48) (1.58)
Exchange rate volatility 0.0293⁎⁎ 0.0509⁎ 0.00742 0.0109
(2.32) (1.90) (0.40) (0.56)
(Export + import) / GDP (%) 0.00413 −0.0000655 0.00219 0.00452
(1.60) (−0.02) (0.83) (1.23)
Log of GDP per capita 0.0301 −0.0550 −0.114
(0.28) (−0.50) (−0.97)
Stock traded / GDP (%) −0.00159 −0.0193 −0.00818
(−0.13) (−1.58) (−1.13)
Number of listed companies −0.00114⁎ 0.000746 0.000505
(−1.71) (1.02) (0.89)
Firm's bribes to government officials (% of firms) −0.0134⁎⁎⁎ −0.0129⁎⁎⁎
(−2.74) (−4.01)
Foreign ownership −0.180
(−0.34)
Indirect exporting firm 1.252
(1.10)
Firm size 0.191
(1.22)
Finance access to commercial banks 0.211
(1.16)
Fairness of court system and corruption −0.222
(−1.47)
Constant 2.258⁎⁎⁎ 2.621⁎⁎ 3.442⁎⁎⁎ 1.957
(8.57) (2.62) (4.19) (1.34)
Observations 105 91 91 91
Adjusted R2 0.046 0.124 0.395 0.554

t statistics in brackets. All regressions include time dummies and country dummies.
⁎ Significant at 10%.
⁎⁎ Significant at 5%.
⁎⁎⁎ Significant at 1%.
10 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13

Table 4
Stock market volatility and corporate corruption (dynamic GMM).

(1) (2) (3)

PGMM PGMM PGMM

Real GDP growth volatility −2.907⁎⁎ −4.202⁎⁎ 2.287

(−2.01) (−2.27) (1.26)
Volatility of inflation rate −0.106⁎⁎ −0.222⁎⁎ −0.0570
(−2.36) (−2.27) (−0.99)
Volatility of real interest rate 0.0311 0.198⁎ 0.0818
(0.48) (1.66) (1.00)
Exchange rate volatility 0.0944⁎ 0.212⁎ 0.0241
(1.76) (1.75) (0.37)
(Export + import) / GDP (%) 0.00765⁎ −0.0107 0.00666
(1.68) (−0.69) (0.59)
Log of GDP per capita −0.0806 0.0386
(−0.14) (0.18)
Stock traded / GDP (%) −0.109 −0.00857
(−1.60) (−0.18)
Number of listed companies 0.00269 −0.000103
(1.22) (−0.11)
Firm's bribes to government officials (% of firms) −0.0166⁎⁎⁎
(−4.11)
Constant 2.058⁎⁎⁎ 3.237 1.721⁎
(3.05) (0.80) (0.79)
Observations 103 89 89
Adjusted R2 0.044 0.054 0.197

t statistics in brackets. All regressions include time dummies and country dummies.
⁎ Significant at 10%.
⁎⁎ Significant at 5%.
⁎⁎⁎ Significant at 1%.

(2009) use a sample for publicly listed firms, and they find strong evidence that the adoption of IAS/IFRS can
reduce asymmetric information of market stakeholders and hence increase minority shareholder protection
and improve corporate governance through a more transparent reporting mechanism. However, using
firm-level data Daske et al. (2013) find that voluntary and mandatory IAS/IFRS adoptions cannot improve
firms' transparency because the reporting incentives as one of firms' broader reporting strategies have been
adjusted in face of the constraints of IAS/IFRS adoptions. As the world becomes more integrated, foreign
investors play an increasing role in the domestic stock market since the year 2000. Tong and Yu (2012) find
strong evidence that foreign investors are more careful about firm's governance quality compared to
domestic investors in China. The authors further conclude that the price divergence between A and B shares
for various public listed firms in China are mainly caused by their corporate governance quality. As the
discount between A and B shares drops significantly in recent years, this may be attributed to a more serious
approach to corruption, as proposed by the Beijing anti-corruption bureau for economic felony.
We can see from model 1 in Table 3 that both economic fundamental variables and monetary policy
variables are statistically insignificant in explaining stock price volatility (adjusted R2 = 0.046). More
importantly, their paper includes many developed countries and only emerging markets, where on
average 45% of firms have to pay bribery to public officials to get things done. Regarding market liquidity
variables, they are more important than economic and monetary policy variables (adjusted R2 = 0.124),
even not individually significant. Not surprisingly, bribery may act as a catalyst that dilutes the effects of
government policies on stock market; as we discussed, bribery makes the government policies more
predictable and therefore reduces the uncertainty that are faced by the market participants. Obviously, in
every economic decision made there are always tradeoffs, and the decision to bribe is no exception. Cost
and benefit of firms' bribes have been extensively examined. However, only recently that a study was
conducted to examine the net benefit of firm's bribes directly. Cheung et al. (2012) use a hand-collected
sample of 166 prominent court cases, which involves 107 publicly listed firms from 20 stock markets that
 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13 11

have been reported to have bribed government officials in 52 countries worldwide, during 1971–2007.
The net benefit of bribe is measured in terms of the residual between change in market capitalization at
the announcement of the award of the contract and the amount of the bribe payment. Their study came to
the conclusion that the net benefit are not particularly large, amounting to 1.7 dollars of benefit per dollar
bribe or 70% of net return per bribery case on average.
A central question in this paper is whether firm's bribery and corporate corruption contribute to
market volatility. The regression results are reported in Tables 3 and 4. From the first two columns, we see
that corporate bribery is statistically significant at 1% level. This could simply reflect the fact that emerging
market with more firms paying bribes will subsequently lead to a more stable stock market, possibly due
to improvement in asymmetric information among market participants. To get an idea of economic
significance of firm's bribery, 10% increase in firm's bribery as the number of firms in the economy would
decrease the volatility of stock returns by 0.13 basis points. Therefore the effect on stock market volatility
is even stronger than that of exchange rate volatility. The explanatory power of model 2 (adjusted R2 =
0.124) in Table 3 is much higher than that of model 3 (adjusted R2 = 0.395), which indicates that a firm's
bribery is very important in playing the role in the stock market volatility. Lastly, the full model takes
account of firm characteristics, including foreign and fairness of court system. As expected, we see that a
more fair court system can decrease stock market volatility, because it helps to prevent the occurrence of
insider trading events; as suggested by Du and Wei (2004) that insider trading and stock market volatility
are positively related. Moreover, foreign ownership is negatively associated with stock return volatility
and the result may suggest that higher foreign ownership can add information content to the market and
make it more transparent to firms and investors.
For robustness check of the findings the estimates reported in Table 4 use Windmeijer (2005) general
method of moment (PGMM) dynamic panel data estimator, with the two-step finite-sample correction, to
use in the small-T large-N panels (T = 7, N = 16 in our case). This estimation strategy can address two
issues. First, the presence of the lagged dependent variable gives rise to autocorrelation, volatility cluster is
well documented, and the correlation is 0.7 between stock market volatility and its first lag. Second,
although our results so far have just shown a correlation between corruption and stock return volatility,
the causal effect is more likely to run from more corruption to less stock market volatility since it is hard to
argue that higher stock market volatility will influence the willingness of an individual firm's bribery.
Nonetheless, there may still be a feedback effect running from the market to an individual firm. That is
more volatility markets may decrease the benefits of giving informal payment to the public officials since
the risk/uncertainty of doing business is higher even if bribery activities are taken place. We use
instrumental variable estimation to address this endogeneity concern. Detailed technical implementation
of the model is discussed. We use the “xtabond2” Stata routine developed by Roodman (2009).
The results of both methods are in line with each other. In the most comprehensive model 3 in Table 4,
the R2 is 0.197. The volatility of inflation rate is statistically significant and negative in the first and second
model specifications without corporate corruption variable. We argue in this paper that bribery reduces
the policy of uncertainty that firms are facing. Therefore when there is wider converge of corporate
corruption, the stock market volatility decreases. The reason is that now it becomes easier to predict the
outcome of the government policy change, and hence eliminate the uncertainty that it imposes on a firm's
performance. The benefits of bribery can be divided into two categories. “According-to-rule” benefits are
any benefits from “getting the things done”. This kind of informal payment can be classified as
“lubrication” payments. This kind of bribery usually involves small payment of gifts to low-ranking
officials to facilitate the performance of official duty; otherwise the officials will refuse to use their office or
perform their duties without illegal payments, for example, changing a passport when it was expired. On
the other hand, the “against-the-rule” benefits involve larger amount of payment to the government
officials or their family members. Therefore extortion occurs in this case; for example, to guarantee
issuance of the license for coal mining without complying with all requirements. Other examples include:
to get guarantee issuance of import permits or visa for expatriate employees, to insure timely installation
of utility services, or to buy a driving license without taking the driving test. By paying more bribes to
the public officials, firms can also reduce the uncertainty that occurs when future government policy
changes because the bribe-takers will help firms “get things done” anyway. Hence, bribery in a sense is like
paying an insurance premium to minimize any uncertainties that investors have to face (Pacini et al.,
2002).
12 C.K.M. Lau et al. / Emerging Markets Review 17 (2013) 1–13

5. Conclusion

This paper investigates the impact of corruption on stock market volatility in 14 emerging markets
with a time period span of 2006 to 2012 along with other detrimental factors like the volatility of
fundamentals and the maturity of the stock markets. In this study we extend the model of Zhang (2012)
by adding additional control variables. The variable that we use for the corporate corruption measure is
from Enterprise Survey of World Bank, which is the “percentage of informal payments to public officials”.
Unlike other measures such as political events or elections, corporate corruption has continuous and
substantial impact on the operations of firms. Corporate corruption is a natural candidate to be that
variable to proxy the uncertainty of firms evolving in the business environment. Zhou and Peng (2012)
discuss that bribery may either grease the wheel of commerce or sand the wheel of growth. The literature
provides evidence in favor of both views. Nevertheless, our analysis was limited by the sample size of 14
countries; we can include more countries in the future when the World Bank updated their database, to
enable researchers to use a longer panel dataset. Another extension could be adding more cultural and
business ethical variables or non-state welfare supports such as families and religions, as suggested by
Cheung et al. (2012), to moderate the effects of firms' bribery. Future researchers may also have to
incorporate shareholders–manager relationship as a moderator for bribery into the model. By using the
World Bank Enterprise Surveys of 2002–2005, Ramdani and Witteloostuijn (2012) show that firm bribery
is more likely to happen if the principal-owner of the firm is male. Another fruitful extension could be the
linkage between market volatility and firm's hedging decision (Lau and Bilgin, 2013).
Our analysis provides insight into the literature of stock market volatility and asymmetric information
of agents. We find that countries with higher corrupted business environment do have less volatile stock
markets, even after controlling liquidity and maturity of the markets, firm characteristics, and economic
variables. The investors consider bribery as a factor reducing the uncertainty that firms are facing.
Therefore, when there is wider converge of corporate corruption, the stock market volatility decreases.
The reason is that now it becomes easier to predict the outcome of the government policy change, and
hence eliminate the uncertainty that it imposes on a firm's performance.

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