CANDIDATE NUMBER

OPENNESS AND CORRUPTION: A CROSS COUNTRY EXAMINATION

ABSTRACT This paper uses panel data along with more traditional approaches to address th e following hypothesis: are higher levels of openness associated with lower leve ls of corruption? It covers 99 nations over the time period 1995-2009 using newl y constructed indicators. Three main indicators of openness are used: trade open ness, financial openness and FDI. It finds our hypothesis , tradeopeness and fi nancial openess reduces corruption , is supported ,as statistically p values a re low. However ,in regard to FDI the results are statistically insignificant . Using traditional approach of karl pearson coefficent , for each of 99 nation s using xlsx , it is observed that country specific conditions ie political , n atural resource environment is probabbly behind diversified nation specific resu lts.. this confirms importance of social capital , the importance of institutio ns such as judicial system , governance.

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CONTENTS PAGE Intro Theory of openness and corruption Literature review Empirical specification -data description -Summary statistics -strategy -multicollinearity results and interpretation -basic model -overall model -lagged model further analysis -correlation matrix -reverse causality problem conclusion bibliography appendix Introduction- max 500 words

Economic literature has emphasised the detrimental effects of corruption on both economic growth and the moral fibre of society. Simultaneously, economists have continued to argue that economic freedom and competition will improve a countrys growth trajectory. Both types of study have focused on the impact of corruption on growth or openness on growth. Direct relationship between openness and corru ption has recently come to academic attention. This paper study makes an attemp t to understand effect of openess of economy ie policy change from from inward to outward looking strategies has on corruption .. This paper uses new indices for corruption and also considers a wider range of o penness indicators. Importance of paper

Corruption has many definitions and interpretations but in this paper, it is def ined as acts in which the power of public office is used for personal gain in a m anner that contravenes the rules of the game (Jain, 2001). He further states that these acts would be severely condemned by the public as those in power have bee n elected to represent national interest; however, their power is abused to maxi mise their own payoffs at the expense of the common good. Due to its illegal nature, corruption has many dire consequences on society. Sch liefer and Vishny (1993) argue that corruption is similar to revenue maximising taxation; however, due to its secretive nature, it requires additional costs, su ch as detection and punishment, and, as a result, is more distortionary than tax ation. For instance, it could enforce substitution into goods provision that is easier and less costly to bribe for such as defence instead of education. More i mportantly, they find that corruption hinders innovation and change as corrupt p oliticians prevent newcomers thereby hampering growth. Mauro (1993) agrees with this view concluding that holding 1980 GDP constant, those countries that have higher corruption levels also have lower private investment. On the other hand, it is important to understand the other side intuitively, ie corruption may have its advantages. Leff (1964) puts forth the idea that a posi tive level of corruption is optimal. Firstly, this may be because government off icials get paid directly for their services so will have an incentive to get the job done efficiently. Secondly, Onerous bureaucratic regulation can be overcome by paying off officials allowing entrepreneurs to reach their targets. Schliefe r and Vishny (1993) who suggest that bribes may be collected for permits and lic enses allowing production expansion support Leffs argument. Nonetheless, the general consensus is strong that the negative consequences of c orruption outweigh the positive ones. Gould and Amaro-Reyes (1983) conclude best saying that corruption has a deleterious effect on administrative performance an d economic and political development. The vast literature out there supports this idea providing strong justification for the continual policy battle to combat t his vice. The significance of corruption in international business dealings is also diffic ult to judge. But to give a sense of scale, if just 5 per cent of $90 Billion of foreign direct investment in developing world in 1995 were paid as bribes , th e total would be $4.5 Billion annually.I f similar value of merchandise imports were diverted into payoff the combined total would be $80 Billion (WORLD BANK 19 96 ,APPENDIX 6 ) THE issue of corruption effects more the nations who have little to say in inter national trade agreements ,.it has greatest impact on poorest in these countries

. It is easy to see corruption. it is difficult to see the structural adjustment p olicies , the so called free trade policies, go to the extent of legal form of c orruption.it is easy to assume tht they are not even issues ,because they are pa rt of laws and institutions that govern national and international communities, and many are accoustomed to it. WHY THESE PARTICULAR YEARS , AND WHY THESE THREE INDICATORS OF OPENESS THE CORE VARIABLES ARE CHOSEN SO AS TO PROVIDE A PARSIMONIOUS SPECIFICATION AND , AT THE SAME TIME TO MINIMIZE THE CHANCES OF OMITTED VARIABLE BIAS ON RELEVANT COEFFICIENTS. Globalization is a process of socioeconomic integration and one of most hotly de bated topics.Its progress is trade openess and foreign direct investment.in vari ous sub parts. on basis of WORLD DEVELOPMENT REPORT 2007 , we can explain INTERN ALIZATION OF TRADE FLOWS $ BILLIONS 1990 1990 2000 2000 2006 2006 INFLOW OUTFLOW INFLOW OUTFLOW INFLOW OUTFLOW CHINA 16 19 21 23 32 39 DC 1 34.5 41.6 53.3 61.9 82.1 72.6 WORLD 32.3 40.0 41.03 50.02 47.3 57.3 INDIA 13.1 16.5 20.3 28.5 28.5 36.7

INTERNALIZATION OF CAPITAL FLOWS (FDI)$ BILLION INFLOW OUTFLOW INFLOW OUTFLOW INFLOW OUTFLOW INDIA 0.5 3.8 0.4 5.7 1.5 CHINA 5.4 1.2 17.9 2.6 11.1 2.8 DC1 10 4.2 26.0 13.3 27.0 14.0 WORLD 8.4 8.7 18.3 19.7 24.8 26.1 PERIOD 1990 1990 2000 2000 2006

2006

There is growing literature that has recognised the existence of interface betwe en FDI and openess. (NOURZAD 2008) ; AIZEMAN &NOY 2006 ; LIU et al 1997 Recent years have witnessed a surge of interest in issues surrounding globalizat ion. A series of financial Crisis in 1990s rekindeled the debates on the effects of removing capital controls. It has led many observers to reconsider gains and pains . FINANCIAL LIBERLIZATION (FINANCIAL OPENESS ) Kaminsky and Schubler 2001, 2002 Schumbler 2003 Many studies have argued capital account liberlization can affect economic devel opment through financial development,First, liberalized financial markets may co ntribute to developing domestic financial sector development Second, financial liberlization MAY MITIGATE FINANCIAL REPRESSION IN PROTECTED F INANCIAL MARKETS Third, it allows the real rate of interest to rise to its competetive market equ ilibrium(McKinnon 1973 Fourth, removing capital; controls allows domesticand foreign investors to engag e in portfolio diversification .The financial liberlization may reduce costs of capital and increasing availibility for borrowers(stultz 1999). financial global ization also reduces the cost of equity capital because of reduction in expected returns, to compensate the risk as well as agency costs . Not at the least liberlization increases the efficiency level of financial syste m by weeding out inefficient financial institutions and creating greater pressur e for reform of financial infrastructure. The magnitude of financial capital has ACQUIRED GLOBAL CHARACTER THEY ACT AS HER D LIKE BEHAVIOUR. The adverse effect is stronger where the institutions needed f or functioning of markets are not well established. WE TAKE FIRST proxy for institutional environment is gdp per capita which is als o used as control variable. THE BASIC MODEL ALSO INCLUDES AN INDEX OF DEMOCRACY TO ACCOUNT FOR THE FACT THAT

REGULAR AND OPEN ELECTIONS MIGHT PROVIDE CHECK ON CORRUPTION, AND AT THE SAME T IME PRODUCE SYSTEMATIC PATTERNS OF TRADE POLICY AND FINANCIAL OPENESS

Theory of the Relationship Openness and Corruption In this paper I analyse the effect of openness on corruption and see whether the re is a negative relationship between the two, i.e. higher levels of openness s are hypothesised to have lower levels of corruption. There are many channels u nder which this is possibility is outlined Very generally, as explicityly sta ted by Bonaglia et al. (2001), openness acts as a constrain on corruption. It ch anges the costs and benefits associated with corruption. ((Frechette (

DO FLOW CHART OVER HERECREATE YOUR OWN this part is very important Trade Openness and Corruption The theory on the impact of trade openness on corruption is vast there may be a formal models to dissect the relationship. But as there are many channels b y which trade openness can reduce corruption , it is felt better to avoid this c omplexity in my emperical work Firstly, Krueger (1974) find that trade restrictions create rent-seeking activit ies and trade policy comes first independent of corruption. Restrictions on impo rts, quotas, tariffs and all other protectionist methods create opportunities fo r rent seeking. Activities such as smuggling and bribery are very common under p rotectionist policy as they allow the importers maintain monopolistic power. As a result, reducing trade barriers should reduce the existence of these rents and reduce corruption. Larrain and Tavares (1999) concur with this view as they sug gest that free trade should leave little room to the policy makers discretion. Fo r instance, excise duties, which are subject to political influence, create ince ntives for private parties to have their way. Furthermore, it can be argued that reducing trade barriers leads to exposure to foreign competition. Ades and Di Tella (1999) are in favour of this view suggest ing that this competition reduces the ability for rent seeking. Gatti (2004) goe s one step further and labels this term the foreign competition effect. This impli es that trade restrictions hamper competition between foreign and domestic firms and give rise to high margins for corruption in the public sector through press ure from monopolistic domestic firms. Gatti (2004) proposes another channel by which trade is beneficial known as the d irect policy distortion. Trade restrictions create opportunities for collusive in teractions between the private and public sector as money moves from the former to the latter in exchange for favourable treatments. following Majeed we uption to sum up the Increase in openness Reduces monopolistic Reduces bureaucratic Decreases ability to use a flow to show the link between trade openness and corr general argument: rents corruption pay a bribe

Financial Openness and Corruption Financial openness impact on corruption has not been thoroughly examined by acade mics. FDI and Corruption The theory on the relationship between FDI and corruption is very scarce but Lar rain and Tavares (2004) provide a useful intuitive explanation of how the former may affect the latter. This may be because the issue of FDI was not so relevant thirty or forty years ago when international capital flows are nowhere near on the same scale as today. Now with very high international capital mobility, fore ign investors can seek returns elsewhere if they feel that corruption levels are too high in a country and that their money may not be put to productive use. We i (2000) supports this idea providing evidence that both American and the Britis h investors are averse to corruption. Rose and Ackerman (1975) claim that corrup tion levels may decline if there are long-term consequences to firms as in the c ase of FDI projects (e.g. infrastructure). Moreover, higher levels of FDI into highly corrupt countries could increase monitoring as foreign investors watch th eir money carefully. This argument, as used in the case of financial openness, c ould reduce corruption as it may make host countries subject to international co urts. For instance, the OECD criminalises commissions to foreign officials due to the link between FDI and corruption as noted by Larrain and Tavares (2004). Previous Research- max 1500 words In ed re he this section, I summarise the findings of the various papers that have analys the impact of openness and corruption and critically evaluate them seeing whe potential issues lie. Nonetheless, empirical literature is inconclusive on t role of openness on corruption as this is a relatively new field of study.

One finding is by Majeed who uses a panel data set for 146 countries over the pe riod 1984-2007 and finds that under a linear specification, trade openness incre ases corruption; however, once non-linearity is introduced, there is a certain t hreshold after which the relationship turns negative. He also finds that trade o penness cannot be used in itself to reduce corruption and other policies need to be tied in, such as financial reforms, so the combined effect will have a posit ive impact on the country. Soudis supports the view that there is a negative rel ationship between openness and corruption but finds that institutional quality Maybe insert and make table for trade openness. No one has used the indicator I have used. FDI has been mostly neglected as mentioned but a few papers have some interestin g finds. Larrain and Tavares are one of the few that delve into this and use pan el data to find both robust and significant results confirming that a higher lev el of FDI is associated with lower levels of corruption. They use both OLS and I V estimation[1] to authenticate this result. Use corruption and openness paper for financial liberalization. Soudis: Knack and Azfar

Majeeds paper uses an old method for corruption ICRG INDEX, uses SUM OF EX AND IM P DIVIDED BY GDP FOR TRADE. Towards the end, one can see that a number of papers seem to have an over-optimi stic view on the impact of openness on corruption. However, it can be seen that despite these findings, one may not be able to suggest that openness uncondition ally reduces corruption but there are many other factors in play that need to be reconciled together. Therefore, this paper does not wholly argue that corruptio n may be reduced by openness but that it is one method that may do. As I will f urther show, this policy may not apply to all countries. Empirical Strategy In this paper, I have chosen to apply panel data analysis rather than cross sect ion analysis as previous studies have done. Under this analysis, the individuals (countries) are observed at several points in time (years). Panel data is most useful when we suspect that the dependent variable (corruptio n) depends on the explanatory variables which are not observable but [a]correlat ed with the observed explanatory variable (openness). In this paper, we use thre e measures of openness that have been constructed using readily observable measu res: trade openness, financial openness and FDI. I have these three as they broa dly cover most aspects of openness. Including more would add complexity to our ana lysis without adding much value. If such omitted variables are constant over tim e, panel data estimators allow us to consistently estimate the effect of the obs erved explanatory variable.[b] The hypothesis I aim to test is whether openness, using a range of indicators, s ignificantly and robustly affects corruption negatively. Furthermore, I will del ve deeper to see if there which of the three openness indicators are the most im portant and whether it supports the existing literature. Lastly, I aim to break up the aggregate analysis to see if this general statement is relevant to all na

tions or whether there are different policy implications depending on status. The Econometric Model Consider the multiple linear regression model for the individual country i=1,2N w ho is observed over several time periods, t=1,2T. Based on this, the regression m odel used is: Yit= + xit + ci + it yit is the dependent variable (corruption). xit is the K-dimensional row vector of the explanatory variable (openness) excluding the constant and is the interc ept. is the K dimensional column vector of the parameters. ci is the nation spec ific effect in this context. it is an idiosyncratic error term that changes both across nations and across time. It is assumed to be uncorrelated with the explan atory variables for each nation across past, present and future time periods. Under the umbrella term, panel data, there are two models I have used in this pa per to estimate the effects of openness on corruption. These are the fixed effec ts and random effects models. The data used is unbalanced because not all the co untries included have values for every year. Both models are estimated using Gen eralised Least Squares (GLS) due to heterogeneity in the variances of the error terms. Using OLS would provide inefficient estimators. We use both the fixed effects model and random effects model to estimate the eff ect of openness on corruption for a range of theoretical reasons. The random effect model includes the individual nation specific variables that a re uncorrelated with the explanatory variables of the past, current and future t ime periods assuming a constant variance. The explanatory variables (the opennes s indicators) are not perfectly collinear and all regressors have non-zero within variance (variation over time for a given nation). The two extreme values of xi t [c]cannot be included as the indicators of openness are slow to change. As the coefficients were coming out to be quite significant, I could take xit to be ex ogenous. In the fixed effects model, one uses only time series information and asks what is expected of the change in the individual nation (for PCI, if there is a one u nit change in the value of xit). In the random effects model, one includes an ad ditional question, that is, using cross sectional information, one asks what is the difference in PCI between two nations if there is a difference in xit by one unit. With such a diverse endogenous structure of nations, the aggregate analysis hide s more than what it reveals, therefore, the Karl-Pearson correlation coefficient s and two-tailed significant tests were undertaken for the explanatory variables and control variables. When we undertake a pair wise study of a few nations wit h diverse bureaucratic political set up, it is very clear that the impact of ope nness is very dependent on the endogenous conditions.

Data Description In this section I will briefly explain the reasons for choosing the indicators t o represent the variables[2]. The period under consideration is 1995-2009 to se e if the relationship between openness on corruption holds with the newly renown ed corruption dataset described below. CORRUPTION BRIEFLY DESCRIBE HOW IT IS MEASURED. For the dependent variable, I use Transparency Internationals Corruption Percepti on Index (PCI). This is an index that began in 1995 and has been very popular in recent years as it is an aggregate indicator that combines different sources of information allowing cross-country comparisons. Despite being well recognised, the PCI still has its drawbacks. For example, year on year surveys may differ du e to different samples rather than due to an actual change in corruption levels. Nonetheless, as it can be easily understood, corruption is a very difficult qua lity to quantitatively measure. Perceptions of corruption are seen to be the nex t best alternative as argued by Transparency International. OPENNESS The three openness indicators, trade openness, financial openness and FDI are de rived from a range of sources. For trade openness, Wacziarg and Welchs (2003) ne wly assembled openness index (WW index) is used, as it is an extension and impro vement of the previously renowned index by Sachs and Warner (SW index)[d]. Howev er, as the analysis is constructed is from the years 1995-99 and the WW index is only available for the years 90-99, estimations were required to be made for 20 00-2009[3]. For instance, the USA has a value of 1 over the period 1990 to 1999 indicating that it was open. Under the criteria of WW, it has also been open af ter 2000; hence a value of 1 was also given for the remaining years. The same ap proach was taken for all other countries. This approach can be further justified as WW found that no countries that were classified as open during the SW period (1970-89) were closed over the WW period. Financial openness has been measured using the Chinn-Ito index (2007). This is a n index that attempts to comprehensively capture the extent of openness in capit al account transactions using a reliable source, the IMF. FDI

Control Variables A few control variables were added to prevent omitted variables bias and capture the effect of openness on corruption after other prominent factors were taken i nto account. Per Capita GDP is included to ensure the size of the country is taken into accou nt because smaller economies may have to be more open to benefit from a larger m arket. More importantly, it may be intuitively evident that less developed econo mies are more likely to be subject to a corrupt government (Easterly and Rebelo 1993). Democracy has been argued to be a check on corruption because open elections mig ht lead to an incumbents party losing the vote due to conspicuous dishonesty. Lastly, Press freedom is included as it has been found to be an important check on corruption. Brunetti and Weder (2003) were reputed for their paper that found a significant and robust causal relationship that runs from lower press freedom to higher corruption across a range of nations.

Due to the large size of the data set, I was unable to include more control vari ables such as ethnolinguistic fractionalisation and oil exporter status. A comprehensive description of the construction of each variable is provided in table 1 in the appendix. Summary Statistics The appendix contains the summary statistics for all indicators categorised by c ontinent. Graphs are also drawn which clearly show a strong correlation between corruption and two openness variables, trade and financial openness. The three c ontrol variables also suggest a relationship with corruption supporting the theo ry that they should be included. Multicollinearity When including a variety of indicators to represent openness in a regression, it is important to check for multicollinearity. Multicollinearity exists when ther e is a perfectly or exactly linear relationship among some or all of the explana tory variables in a regression model. It may arise for a range of reasons. It m ay be due to a flaw in the data collection method or constraints on the model. A lternatively, there may be model misspecification or an overestimated model. If our openness indicators are collinear, then our coefficients are meaningless and we should only use one instead of three. In our results, we use only one method to check for multicollinearity. Firstly, I use the variance inflating factor (VIF) test where VIFj= 1/(1-R2j) I regress each explanatory variable on the others and find R2j for each regressi on. As R2j approaches one, the VIF approaches infinity. Variances of the explana

tory variables are directly proportional to the VIF so they are inflated if the R2j is high. As a rule of thumb, if the VIF value is greater than 4, then multic ollinearity should be further investigated[4]. The table below shows the results of the VIF test: VIF 1/VIF Trade Open 1.3 0.769230769 Fin Open 1.64 0.609756098 FDI 1.09 0.917431193 PCGDP 1.49 0.67114094 Therefore, as one can see, as all the VIF values are very low, one should not be concerned with multicollinearity under this measure. Results and Interpretation In this section, I will interpret the results obtained by running the appropriat e regressions based on the explanation given in the empirical strategy. Firstly, I ran two simple GLS random and fixed effects regressions. The LHS vari able is PCI and the RHS variables are all listed in the table below. Each column represents a single regressions, i.e. column 1 is the regression of corruption on trade openness only. The tables below provide the relevant information: Table (individual RE)

Trade Open Fin Open FDI PCGDP Democracy Press Freedom RE RE RE RE RE RE Coefficient 2.128 0.078 0.000

0.000018 0.002 -0.014 Std. Error 0.551 0.021 0.000 0.000 0.002 0.002 t-stat 3.860 3.660 -0.530 6.610 0.930 -6.250 P-value 0.000*** 0.000*** 0.599 0.000*** 0.351 0.000*** Corr(ui,x) 0(assumed) 0(assumed) 0(assumed) 0(assumed) 0(assumed) 0(assumed) Wald chi2 14.930 13.400 . 43.680 0.870 39.080 P>chi2(1) 0.000 0.000 . 0.000 0.351 0.000 Sigma_u 2.154 1.863 2.161 1.028 2.006 1.596 Sigma_e 0.447 0.446 0.447 0.447 0.436 0.446 Rho

0.959 0.946 0.959 0.841 0.955 0.928 Observations 1291 1291 1291 1291 1254 1284 R2 0.142 0.324 0.042 0.686 0.106 0.489 ***indicates significant at the 1% level, ** indicates significant at th e 5% level and * indicates significant at the 10% level. Table (individual FE)

Trade Open Fin Open FDI PCGDP Democracy Press Freedom FE FE FE FE FE FE Coefficient . 0.055 -2.930E-13 0.000004 0.001 -0.008 Std. Error . 0.021 7.520E-13 0.000 0.002 0.002

t-stat . 2.580 -0.390 1.610 0.660 -3.660 P-value . 0.010* 0.697 0.107 0.512 0.000*** Corr(ui,x) 0.000 0.553 0.206 0.835 0.326 0.669 Prob>F . 0.010 0.697 0.107 0.512 0.000 Sigma_u 2.306 2.260 2.305 2.259 2.255 2.182 Sigma_e 0.447 0.446 0.447 0.447 0.436 0.446 Rho 0.964 0.963 0.964 0.962 0.964 0.960 Prob>F 0.000 0.000 0 0.000 0.000 0.000 Observations 1291 1291 1291

1291 1254 1284 R2 0 0.3235 0.0421 0.6862 0.1058 0.489 ***indicates significant at the 1% level, ** indicates significant at th e 5% level and * indicates significant at the 10% level. Looking at the coefficient on trade openness for the random effects model, one c an interpret that opening up to trade (as the trade index is a dummy variable) wil l lead to an increase on the PCI index of 2.128 points. For example, it implies that if India (PCI 3) opened up to trade according to the WW index, it would bec ome as corrupt as Hungary (PCI5). These results are significantly significant at the 5% level and robust due to the high Rho coefficient[5] (0.959). On the othe r hand, the coefficient on trade is dropped in the fixed effects model because t he within and in between R2 values came out to be zero. This may be because the erro r terms are correlated with trade so fixed effects is not a suitable model for t his regression. A more likely reason is that the data lacks variation both withi n countries and across. For instance, Germany has a value of 1 over the 15 year time period as it remained open. Therefore, the random effects model is more app ropriate in this setting. Progressing over to financial openness, once again one can see a highly signific ant and robust coefficient both under random and fixed effects estimation. On an aggregate level, it implies that a one unit increase in financial openness (sma ll scale continuous increase unlike the significant jump expected under trade op enness) will lead to an increase on the PCI scale of 0.078 and 0.055 under rando m and fixed effects respectively. This is in contrast with the findings of Gatti (2004) who claimed his results were insignificant most likely because financial openness indicator he used only focused on controls and not intensity. As our m easure includes intensity, it is more comprehensive and for this reason makes ou r findings more concrete. The most interesting result of the three indicators is the coefficient on FDI. T he coefficient appears to be virtually zero and insignificant for both fixed and random effects. This is in contrast to the literature that emphasises that FDI has an important link with corruption[6]. However, despite the fact that one wou ld not reject the null that FDIs coefficient is zero econometrically, one still c annot dispute Larrain and Tavares findings based on this paper. Firstly, this is because the time period I have used is post-1995 where as they used 1970-1994.[e ] Moreover, they created a gravitational instrument variable to proxy for FDI du e to the reverse causality issue. This will be discussed in greater detail in th e endogeneity section. Secondly, the impact of FDI on corruption cannot be disre garded as this regression is based on an aggregate study including a heterogenou s selection of countries. Later on, I will discuss individual nations to show th at the impact will vary across countries. The table below is the fixed effects estimation for each of the openness indicat ors including the control variables:

NEED ONE LINE TO SHOW THAT FIXED EFFECTS SUPPORTS RANDOM EFFECTS OR SOMN AND FIT S VALIDITY OF MY CONCLUSIONS.

Above we exclude trade once again for the same reasons as proposed before (lack of within and in between variation). The coefficient on financial openness has f allen in comparison to the coefficient estimated without control variables from 0.055 to 0.050 indicating an overestimation due to omitted variables bias. The c oefficient on FDI is still virtually zero and insignificant for the potential re asons mentioned earlier. The table below provides results for both random and fixed effects for all openn ess indicators run together. Table Variables 1 2 random effects fixed effects Trade Open 1.414 . (0.000)*** . Fin Open 0.058 0.040 (0.010)* (0.061)* FDI -1.240E-13

-2.200E-13 (0.878) (0.765) PCGDP 0.000 0.000 (0.000)*** (0.194) Democracy -0.003 -0.001 (0.131) (0.599) Press Freedom -0.018 -0.007 (0.000)*** (0.003)** Constant 3.842 4.849 (0.000)*** (0.000)*** Observations 1254 1254 R2 0.500 0.629 P values are in parentheses. ***indicates significant at the 1% level, **indicates significant at the 5% level and * indicates significant at the 10% l evel.

To account for potential endogeneity, I also lag each of the variables by one ye

ar and repeat the random and fixed effects regression. This is because it is unl ikely that corruption will affect, for example, past levels of per capita GDP or FDI. It is also interesting to see if the impact of opening up has a time lag. Th e table of results is below: Table (individual lag RE)

Lagged Variable Trade Open Fin Open FDI PCGDP Democracy Press Freedom RE RE RE RE RE RE Coefficient 2.148 0.058 4.000E-13 1.520E-04 0.001 -0.011 Std. Error 0.552 0.020 7.370E-13 2.680E-06 0.002 0.002 t-stat 3.890 2.920 0.540 5.690 0.680 -4.890 P-value 0.000*** 0.003** 0.587 0.000*** 0.495 0.000***

Wald chi2 15.160 8.540 . 32.350 0.470 23.960 P>chi2(1) 0.000 0.004 . 0.000 0.495 0.000 Sigma_u 2.158 1.847 2.173 1.027 2.109 1.597 Sigma_e 0.420 0.419 0.420 0.420 0.420 0.420 Rho 0.964 0.951 0.964 0.968 0.962 0.935 Observations 1245 1245 1245 1245 1245 1238 R2 0.141 0.327 0.038 0.689 0.088 0.487 ***indicates significant at the 1% level, ** indicates significant at th e 5% level and * indicates significant at the 10% level.

Table (individual lag FE)

Lagged Variable Trade Open Fin Open FDI PCGDP Democracy Press Freedom FE FE FE FE FE FE Coefficient . 0.037 4.960E-13 1.680E-06 0.001 -0.005 Std. Error . 0.020 7.340E-13 2.470E-06 0.002 0.002 t-stat . 1.860 0.680 0.680 0.440 -2.360 P-value . 0.063* 0.499 0.496 0.657 0.019** Corr(ui,x) 0.000 0.563 -0.202 0.839

0.298 0.683 Prob>F 0.000 0.063 0.500 0.496 0.657 0.019 Sigma_u 2.312 2.280 2.314 2.293 2.310 2.235 Sigma_e 0.420 0.419 0.420 0.420 0.420 0.420 Rho 0.968 0.967 0.968 0.968 0.968 0.966 Prob>F 0.000 0.000 0.000 0.000 0.000 0.000 Observations 1245 1245 1245 1245 1245 1238 R2 0.000 0.327 0.038 0.689 0.088 0.487 ***indicates significant at the 1% level, ** indicates significant at th e 5% level and * indicates significant at the 10% level. Looking at the lagged explanatory variables above, one can see that both trade a nd financial openness are still statistically significant and robust under the r andom effects model but the only the latter is for the fixed effects model. FDI, once again, does not have any statistical significance. Further Analysis

The analysis so far has relied on aggregate data for a vast number of countries across the globe. However, it is very important to note that despite the finding s that openness has a negative impact on corruption based on this paper, one can not confidently conclude that all nations that have followed isolationist polici es and are highly corrupt (e.g. ) should definitely open up. There is a high deg ree of heterogeneity between countries and one would be incorrect to recommend t he same policy to Rwanda as one would to Costa Rica. As a result, I decided to i nvestigate this glaring query by creating a correlation matrix for each country to see the connection between each variable and corruption using the Pearson Cor relation coefficient for all 99 countries. Pearson is a technique for investigat ing the relationship between two quantitative, continuous variables[7]. The resu lts below pick out a few distinctly different countries to prove this point[8]. Angola Iran Singapore Belgium Japan PCI PCI PCI PCI PCI TRADE OPEN . . . . . . . . . . FIN OPEN -0.267 -0.524 0.577 0.894 0.663 0.487 0.045* 0.024* 0.000* 0.007* FDI -0.707 0.421 0.264 0.128 -0.646 0.033* 0.118 0.341

0.649 0.009* PCGDP 0.491 -0.918 0.208 0.601 0.275 0.179 0.000* 0.457 0.018* 0.321 DEMOCRACY 0.468 0.568 . -0.286 . 0.204 0.027* . 0.302 . PRESS FR -0.741 -0.634 0.380 -0.733 0.363 0.022* 0.011* 0.163 0.002* 0.184 .p-values are below each coefficient

*represents that coefficient is significant at the 5% level

Above, we can see that the correlation between PCI and two openness indicators i s markedly different across the nations. For instance, for Iran, there is a stro ngly significant negative correlation between financial openness and corruption. This could be because as argued by... Furthermore, FDI shows a strong negative corr elation with corruption for both developing nations, Iran and Angola. On the oth er hand, for more developed economies such as Singapore, Belgium and Japan, ther e is a significant positive correlation between financial openness and corruptio n. This simple analysis has an important meaning that one cannot simply recommen d to developing nations that they should open up their financial sectors. Waczia rg and Welch (2003) concur with this argument suggesting that openness does not help an economy that is very poor and very corruptas evident from the 1990s when many countries opened up. Despite high returns in these nations, increasing inf lows will only increase rents that could potentially go into the wrong hands inc reasing inefficiency and not aiding development.

Reverse Causality Problem The one primary issue with this analysis is the issue of reverse causality betwe en corruption and openness as theory does not clearly indicate whether or not op enness is exogenously determined. Wei (2000) argues that openness is exogenously determined based on economic policy. Looking at the construction of our indices , there may be reverse causality issues with trade openness as tariffs may be de termined by corrupt politicians seeking to revenue maximize as suggested later b y Wei (2005). Also, there may be an issue with FDI as higher levels of corruptio n could deter foreign investors from entering the country. GIVE RUSSIA EXAMPLE H ERE. As I have dealt with a vast panel data set it was very difficult to deal with th is problem so I shall simply present the potential issues with it and if they ar e strongly relevant or not. Ideally, a proxy could have been created for each en dogenous variable and a 2SLS approach taken to ensure causality ran solely from corruption to openness. For instance, in the literature, Ades and Di Tella (1999 ) use import capacity as a proxy for openness as it is determined by land size a nd population; characteristics unaffected by corruption. Nonetheless, the issue of reverse causality is unlikely to affect financial openness (our key indicator ) and as the FDI results proved insignificant, biased results are not a problem. Even so, if corruption affected openness, then higher corruption levels would on ly reduce openness as rents would want to be contained within the country for th e corrupt officials to keep. As a result, a low PCI value would mean a lower val ue for each openness indicator at the aggregate level. The size of the variables may change but the sign of the variables would not as there is a positive upwar ds bias. Our results may be mildly overestimated in this respect but not enough to indicate the opposite correlation. Therefore, the reverse causality issue may not be so detrimental to our analysis after all. FINDING instrumental VARIABLE FOR fdi is hard and tricky.- THE BASIC STRATEGY I N INSTRUMENAL VARIABLE ESTIMATION IS TO FIND AN ESTIMATOR THAT IS BOTH CONTEMPOR AEOUSLY UNCORRELATED WITH THE ERROR TERM FROM THE ORIGINAL MODEL , AND PROBABLY

SHOULD BE HIGHLY CORRELATED WITH REGRESSOR, FOR WHICH IT IS TO SERVE AN INSTRUME NT. FUTHERMORE THE INSTRUEMENT CAN HAVE DIRECT EFFECTS ON DEPENDENT VARIABLE. THESE STRONG REQUIREMENTS REQUIRE REGRESS DATA BUILT UP AND STRONG EXPERIENCE IN BUILDING LITERATURE YEAR TO YEAR EFFECTS VARIATION ON CORRUPTION INDEX IS NOT VERY INFORMATIVE BECA USE OF HIGH MEASUREMENT ERROR Conclusion and Policy Recommendations Conclude: on aggregate level, openness does negatively impact corruption But, need different policies for different nations Perhaps poor countries need to remain Bibliography

Chinn, Menzie D. and Hiro Ito (2008). "A New Measure of Financial Openness". Jou rnal of Comparative Policy Analysis, Volume 10, Issue 3, p. 309 322 (September) Wacziarg, R. and K. H. Welch (2003).Trade Liberalization and Growth: New Evidence . Working Paper No. w10152, NBER, Cambridge, MA. Neeman, Z., M. Daniele Paserman, and Avi Simhon (2008) Corruption and Openness, Th e B.E. Journal of Economic Analysis & Policy : Vol. 8: Iss. 1 (Contributions), A rticle 50.Volume 8, Issue 1 2008 Article 50

Larrain, B. and Jose Tavares (2004). Does Foreign Direct Investment Decrease Corr uption?

CUADERNOS DE ECONOMIA, VOL. 41 (AGOSTO), PP. 217-230, 2004 DOES FOREIGN DIRECT I NVESTMENT DECREASE CORRUPTION?*FELIPE LARRAN B.Pontificia Universidad Catlica de Chile JOS TAVARES Universidade Nova, Portugal Can Openness Deter Corruption?* Felipe Larran B. Center for International Development Harvard Institute for International Development and John F. Kennedy School of Government Harvard University Jos Tavares Harvard Institute for International Development Harvard University August 1999 Trade, Economic Freedom and Corruption: Cross-Country Evidence Muhammad Tariq Majeed*

University of Glasgow Trade Openness and Corruption Revisited: Do Institutions matter? Dimitrios Soudis Graduate School Assessing the Emerging Global Financial Architecture: Measuring the Trilemma s C onfigurations over Time Joshua Aizenman, Menzie D. Chinn, and Hiro Ito NBER Working Paper No. 14533 December 2008 JEL No. F15,F21,F31,F36,F41,O24 Trade Liberalization and Growth: New Evidence Romain Wacziarg and Karen Horn Welch NBER Working Paper No. 10152 December 2003 JEL No. F1, F4, O4 Journal of International Development J. Int. Dev. 16, 851861 (2004) Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.100 2/jid.1115 EXPLAINING CORRUPTION: ARE OPEN COUNTRIES LESS CORRUPT? ROBERTA GATTI* The World Bank, Development Research Group, Washington DC, USA

Fortune or Evil? The Effects of Inward Foreign Direct Investment on Corruption_ Pablo M. Pintoy and Boliang Zhuz March 31, 2008

Corruption Andrei Shleifer; Robert W. Vishny The Quarterly Journal of Economics, Vol. 108, No. 3. (Aug., 1993), pp. 599-617. Ades and di tella Mauro Leffe Wooldridge

Baltagi World bank Brunetti, Aymo and Beatrice Weder. 2003. A Free Press is Bad News for Corruption. Journal of Public Economics 87:1801-1824. Jain, A. (2001). Corruption: A Review. Journal of Economic Surveys 15(1), 71-121 . Gould, David J., and Jose A. Amaro-Rayes, (1983) The Effects of Corruption on Adm inistrative Performance, World Bank Staff Working Paper No. 580 (Washington, DC: The World Bank, 1983). Appendix Data description Table 1- Data Description Variable Description Corruption Index The Corruption Perceptions Index ranks countries based on how corrupt th eir public sector is perceived to be. A countrys score indicates the perceived le vel of public sector corruption on a scale of 0 - 10, where 0 means that a count ry is perceived as highly corrupt and 10 means that a country is perceived as ve ry clean. Surveys include questions related to the bribery of public officials, kickbacks in public procurement, embezzlement of public funds, and the effective ness of public sector anti-corruption efforts. Perceptions are used because corr uption is to a great extent a hidden activity that is difficult to measure. Over time, perceptions have proved to be a reliable estimate of corruption. Data is available from 1995 2011 for 183 countries. Source: Transparency International Trade Openness Wacziarg and Welch trade dummy is an extension of the Sachs and Warner d ummy. A country is defined as open if all the following criteria are met: 1) the average of unweighted tariffs in the period is lower than 40%; 2) the average o f core non-tariff barriers on capital goods and intermediates is lower than 40%; 3) the average black market premium over the period is lower than 20%; 4) the c ountry does not have an export marketing board; 5) the country is not socialist. Data is available for 141 countries. Source: Wacziarg, R. and K. H. Welch (2003).Trade Liberalization and Growth: New Evidence. Working Paper No. w10152, NBER, Cambridge, MA. Financial Openness The Chinn-Ito index (KAOPEN) is a de jure index measuring a country s de gree of capital account openness. KAOPEN is based on the binary dummy variables that codify the tabulation of restrictions on cross-border financial transaction s reported in the IMF s Annual Report on Exchange Arrangements and Exchange Rest rictions (AREAER). This index takes on higher values the more open the country i s to cross-border capital transactions. By construction, the series has a mean o f 0. Values range from -1.86 to 2.46. Data is available from 1970-2010 for 181 countries. Source: Chinn, Menzie D. and Hiro Ito (2008). "A New Measure of Financial Openne

ss". Journal of Comparative Policy Analysis, Volume 10, Issue 3 Foreign Direct Investment Foreign direct investment is net inflows of investment to acquire a last ing management interest (10% or more of voting stock) in an enterprise operating in an economy other than that of the investor. It is the sum of equity capital, reinvestment of earnings, other long term capital, and short term capital as sh own in the balance of payments. This series shows total net FDI in the reporting economy from foreign sources less net FDI by the reporting economy to the rest of the world. Data are in current U.S. dollars from 1960 2010 for 216 countries. Source: World Bank Per Capita GDP GDP per capita is gross domestic product divided by midyear population. GDP is the sum of gross value added by all resident producers in the economy plu s any product taxes and minus any subsidies not included in the value of the pro ducts. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources. Data are in curre nt U.S. dollars from 1960-2010 for 216 countries. Source: World Bank Democracy Index The POLITY score is computed by subtracting the AUTOC score from the DEMOC score; the resulting unified polity scale ranges from +10 (strongly democr atic) to -10 (strongly autocratic). Democracy and autocracy measures are derived from the weighted codings of the competitiveness of political participation, th e regulation of participation, the openness and competitiveness of executive rec ruitment and constraints on the chief executive. Data is available from 1800-201 0 for 164 countries. Source: Polity IV Press Freedom The index is focused on ability to access news and information (which pr edominantly means print and broadcast media but can also including blogs, social media, and other forms of digital news dissemination) and providers of news con tent. Countries are given a total score from 0 (best) to 100 (worst) on the basi s of a set of 23 methodology questions divided into three subcategories: legal, political and economic environment. A combined score of 0-30=Free, 31-60=Partly Free, 61-100=Not Free. Data is available from 1980-2011 for196 countries. Source: Freedom House 99 countries list Albania, Angola, Argentina, Armenia, Australia, Austria, Azerbaijan, Ban gladesh, Belarus, Belgium, Bolivia, Botswana, Brazil, Bulgaria, Cameroon, Canada , Chile, China, Colombia, Costa Rica, Cote DIvoire, Croatia, Czech Republic, Denm ark, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Ethiopia, Finland , France, Georgia, Germany, Ghana, Greece, Guatemala, Honduras, Hong Kong, Hunga ry, Iceland, India, Indonesia, Iran, Ireland, Israel, Italy, Jamaica, Japan, Jor dan, Kazakhstan, Kenya, Republic of Korea, Latvia, Lithuania, Macedonia, Malawi , Malaysia, Mauritius, Mexico, Moldova, Morocco, Mozambique, Netherlands, New Ze aland, Nicaragua, Nigeria, Norway, Pakistan, Panama, Paraguay, Peru, Philippines , Poland, Portugal, Romania, Russia, Senegal, Sierra Leone, Singapore, Slovak Republic, Slovenia, South Africa, Spain, Sweden, Switzerland, Tanzania, Thailan d, Trinidad and Tobago, Tunisia, Turkey, Uganda, Ukraine, UK, USA, Uruguay, Vene zuela, Yemen, Zambia.

Summary Statistics

Continent All countries (99) Africa (20) Asia (17) Europe (38) South America (10) North America (12) Australasia (2) Variable Mean STDEV Mean STDEV Mean STDEV Mean STDEV Mean STDEV Mean STDEV Mean STDEV CPI 4.52 2.35 3.15 1.15

3.92 2.21 5.62 2.33 3.61 1.61 4.20 2.00 9.06 0.54 Trade Open 0.81 0.41 0.60 0.50 0.65 0.49 0.87 0.31 1.00 0.00 1.00 0.00 1.00 0.00 Fin Open 0.80 1.35 -0.31 1.29 0.30 1.46 1.28 1.12 0.77 1.01 1.67 0.94 1.95 0.75 FDI (millions)* (225) 14,429 704 929 3,020 18,293 (3,360) 10,818 3,712 5,339 (436) 8,934 4,036 2,828 PCGDP 10,387 11,469 1,338 1,464

7,436 11,188 17,904 14,368 4,072 2,110 8,729 11,848 24,691 5,193 Democracy 5.05 7.45 -0.86 8.39 1.44 5.81 7.89 4.52 7.01 2.76 8.53 1.27 10.00 0.00 Press Freedom 40.58 23.55 54.28 15.93 55.60 18.96 30.43 19.82 41.13 11.80 33.02 14.87 11.50 2.97 *brackets indicate that values are negative

________________ [1] The IV estimation will be discussed more in depth in the reverse causality s ection [2] For a full description of how each indicator is constructed, refer to Table 1 in the appendix. [3] Out of the 99 countries in the dataset, only two countries opened up after 2001, Pakistan and Sierra Leone. The rest remained open or closed as they were o ver the measured period. [4] REMEMBER TO FOOTNOTE THE SOURCE OF THIS [5] A high Rho value indicates that the error term is uncorrelated with the expl anatory variable. [6] Larrain and Tavares (2004) claimed this extensively. [7] Trade openness has been left out as it is a discrete, binary variable. [8] As the correlation matrix is very large, I have chosen to only include in th e table below the correlation of each variable with PCI for the various countrie s selected. [a]Gabriel said to add time invariant Anish Gupta [b]Gabriel said that this last line seems to refer to FDI etc.. Anish Gupta [c]Gabriel said to use its name- openness? Anish Gupta [d]Briefly need to describe how it has improved Anish Gupta [e]Gabriel said so maybe things have changed? Anish Gupta