The role of corruption in the context of financial repression: evidence from China

Abstract

Mauro (1995) argues that corruption hinders private investment. Following him, existing research generally assumes that corruption and business investment are negatively and linearly correlated. However, in this research, using the case of China, we find that the effect of corruption on investment, first, depends on the nature of enterprises; second, can be nonlinear, that is, up to certain points, corruption may be a lubricant for private enterprises to get bank loans in a financially repressed system. Financial repression in China allows government officials to channel bank loans to preferred State-Owned-Enterprises (SOEs) but discriminate against private enterprises. Bureaucrats in charge of loan allocation get opportunity to seek rents from potential clients with rare access to credit. Thus, the effect of corruption on firms’ investment decisions is heterogeneous and nonlinear. Corruption will not affect the SOE investments and will be significantly associated with private investments. It may boost private investments by lowering the financial cost so long as corruption cost is low enough to keep the project profitable. Corruption will deter private investments when the bribee charges more than what the project can afford. These hypotheses are testified using the industrial sector data from hundreds of Chinese enterprises. Corruption only affects private firm’s investments in an inverted U manner: it does not decrease private investment unless corruption level surpasses a threshold. In other words, less corruption lowers financial cost of private investments but more corruption will increase the financial costs to make the investment non-profitable anymore.