Does corruption bother you?

I ask the professional institutional investor, not the woke consumer or spiritual guide, in you.

We all say that of course it does but, in practice, is this or should this be the case?

These questions are particularly relevant for emerging markets and ESG investors (in emerging and developed markets).

I struggle with the response to these questions but make the following suggestions in this report:

Corruption does not always inhibit investment returns on the time frames institutional investors are rewarded on, but the negative effects of corruption ultimately catch up with a country (comparing Brazil over two time frames, 2012-19 and 2016-19, show that equity performance can veer in a wildly different direction to corruption metrics);
Measuring corruption, proving the link between corruption and poor economic performance, and identifying what counts as sincere anti-corrupt policies are all problematic (for example: China's corruption scores, since 2012, have improved meaningfully in the World Bank's Control of Corruption index, but barely moved in Transparency International's Corruption Perceptions index; China's poor scores on corruption have not inhibited higher growth more than large emerging market peers; movements in the World Bank measure, since 2000, are in the opposite direction to changes in the rate of economic growth; and most would agree the anti-corruption drive under President Xi Jinping has been motivated at least as much by concentrating power as by cleaning up the political economy); and
ESG investing needs to acknowledge the inconsistency and incompleteness in supposedly objective measures of corruption and, equally importantly, to treat corruption in developed and emerging markets consistently (by acknowledging that illicit financial flows from supposedly corrupt emerging markets end up in supposedly clean developed ones).

How can something so wrong feel so right?

“When you see that money is flowing to those who deal, not in goods, but in favors—when you see that men get richer by graft and by pull than by work, and your laws don’t protect you against them, but protect them against you—when you see corruption being rewarded and honesty becoming a self-sacrifice—you may know that your society is doomed” (Ayn Rand, Atlas Shrugged, 1957).

A slow and silent killer

Almost everyone would agree that corruption is a serious negative for a country's investment case because it causes:

Economic inefficiency (eg bribes have a much bigger impact than simply making up for low salaries in the public sector, capital is allocated not to the most efficient operators but the most privileged, productivity declines because it is not fairly rewarded, and active rent-seeking increases);
Lower tax collection (and usually higher tax rates on incomes and wealth that are officially documented); and
Drives capital of all types (human, physical, financial) overseas (whether legally or illicitly) with a relatively small offset in the form of remittances (whether via official or undocumented channels).

Corruption catches up with a country, ultimately

Countries that score poorly in corruption metrics, even where these scores deteriorate, may nonetheless display high economic growth and/or offer institutional investors very high returns on the time frame on which they are rewarded.

The issue of time frame is critical.

Ultimately, high, and worsening, levels of corruption catch up with a country. For investors, it is a question of whether the period before this day of reckoning (the catalyst for which could be civil disruption, currency collapse or flight of hot capital), is long enough to build and exit portfolio positions in an orderly manner.

Consider the example of Brazil compared with large EM peers:

2016-19 out-performance
- Brazil's Transparency International Corruption Perception Index score fell by 13% between 2016 and 2019. In real terms. GDP did not grow. But the MSCI Brazil equity index increased by 135%.
- Over the equivalent 2016-19 period, in the seven other largest markets in EM (which make up over 75% of the MSCI EM index), the average change (weighted by GDP) in the corruption index score was a 2% improvement, combined real GDP expanded by almost 25%, but the MSCI EM index was up merely 40%.
2012-19 under-performance
- Brazil's corruption score fell 19% between 2012 and 2019, real GDP expanded merely 2% and MSCI Brazil decreased over 15%.
- Over the same time period, the other seven largest markets in EM saw an average change (weighted by GDP) in the corruption index score was a 6% improvement, combined real GDP expanded almost 60% and the MSCI EM was up over 20%.

Of course, being able to predict the exact moment when well-understood vulnerability is exposed is exceedingly difficult (which is why, in my strategy work generally, I tend to focus, instead, on valuations relative to history – this does not help with timing but it indicates what compensation there is for downside risk).

Corruption academics and data: Unclear takeaways

Academic literature on corruption is not as clear-cut as one might expect. No one denies the negative impacts of corruption described above. However, there is plenty of debate over how to measure corruption and its impact on the economy and what anti-corruption policies to deploy in response.

Different measures of corruption can paint very different pictures of the same country: eg Pakistan scores much worse in the Transparency International Corruption Perceptions Index compared with Malaysia but historical illicit financial flows as a percentage of GDP appear to be much lower.

The impact of corruption on government tax revenue is not obvious from a sample of data across emerging markets (in the chart below, countries with similar levels of corruption can have very different levels of tax revenue to GDP).

Levels of corruption do not clearly correlate with GDP growth; ie similarly corrupt or clean countries can exhibit very different growth (ie other factors may dominate for sustained period, eg population demographics, commodity prices, interest rates, currency).

The change in levels of corruption often do not correlate well with GDP growth rates. In the charts below, the trajectory of control of corruption does not always lead or coincide with that of real GDP growth. The prime example is China where low scores on the World Bank's control of corruption index have not inhibited very high growth, a deterioration in its score coincided with an acceleration in growth (2000-08) and an improvement in its score coincided with a deceleration in growth (2010-18).

Policies to encourage growth (eg privatisation of state enterprises) may also foster corruption (capture of the privatisation process by vested interests). However, growth itself may be part of the solution for corruption (eg the associated benefit of improvements in education, the broadening of the middle class, competition from new entrants).

“While here is little development without control of corruption, there is also no progress on control of corruption without significant civil society development.” (Mungiu-Pippidi and Hartmann, 2019)

Anti-corruption policies: Permanent reform is rare

In any political economy, emerging or developed, small or large, pluralistic or autocratic, anti-corruption drives rarely deliver permanent positive reform, certainly when compared with the number of times anti-corruption campaigns are publicly announced, and they almost never achieve these gains quickly:

Vested interests in corruption (which include geopolitically motivated international powers), which have spent decades reinforcing their patronage networks, can frustrate anti-corruption efforts after even the most egregious public examples, and can reverse previous improvements;
Anti-corruption campaigns can be thin veils for political persecution of or political score-settling with opposition politicians;
The economic disruption from the resulting paralysis in decision-making by bureacrats and politicians and capital investment decisions by the private sector (with all parties fearful of future scrutiny of the contracts they sign) can erode the political will for a clean-up.

There is nothing unique about a particular country or region in this respect. The emerging markets examples highlighted below are deliberately chosen from a wide spectrum.

LatAm democracies
- The Odebrecht scandal implicated many in the political class across the continent but it is not clear that lasting legal safeguards have been put in place to avoid a repeat. Indeed, part of the defence tactic of those accused under the investigations, such as the Odebrecht one, has been to politicise corruption charges and brand them as part of a broad campaign to discredit and weaken "progressive" leaders (eg Cristina Fernandez in Argentina, Evo Morales in Bolivia, Lula de Silva in Brazil, Rafael Correa in Ecuador).
- Argentina: The legal momentum behind anti-corruption cases involving former President Cristina Fernandez appears to be weakening following the election of current President Alberto Fernandez (Cristina is the vice president) and the change of leadership he implemented at the head of the anti-corruption office (Crorus).
- Peru: The vested interests that still dominate the legislature and judiciary, in the face of efforts by President Vizcarra and support of the electorate, have mounted effective opposition to anti-corruption reforms.

Africa democracies
- Kenya: While anti-corruption is a popular message, the actions taken by President Kenyatta in his second term (which include reconciling with elements of the opposition and proposing constitutional reform to weaken the future role of the presidency) likely have much more to do with strengthening his Kieleweke faction relative to Vice President Ruto's Tangatanga faction in the ruling Jubilee coalition as the crunch of the 2022 election (and the succession implied by the two-term limit on Kenyatta).
- Nigeria: Following two terms under President Jonathan (towards the end of which the well-respected central bank governor was suspended for raising concern over missing oil revenue), the election of President Buhari initially sparked structural reform of governance (moving to a single treasury account, instituting regular public audits of the state oil company, wholesale changes of personnel in the bureaucracy). But this appeared to run out of steam quickly thereafter (and arguably went into reverse under the multi-currency regime, which created unfair competitive advantage for those able to access foreign currency at the strongest rate). Nigeria's Transparency International corruption score in 2019 is very close to what it was prior to Buhari's election win in 2015.
South Asia democracies
- Bangladesh: The use of anti-corruption as a means to persecute and weaken those politicians sitting in the opposition precedes the post-2009 era of the de facto one-party state under the Awami League (ie the Bangladesh National Party and, during periods of martial law, the Army, has also used this tactic).
- Sri Lanka: Former President Sirisena won the election in 2015 on an anti-corruption platform (following a decade under the Rajapaksa presidency that saw transitions from civil war, to peace and macroeconomic relaunch, to increasing authoritarianism and crony-capitalism). Yet, within two years, both the central bank governor and the finance minister were accused of corruption. Sri Lanka's Transparency International corruption score hardly changed between 2015 and 2019.
Asia one-party states
- China: The 2012-16 anti-corruption program under President Xi Jinping was one part of the effort to consolidate support among allies and remove potential dissenters and rivals (eg Bo Xilai) in advance of the Communist Party Congress of 2017;
- Vietnam: When anti-corruption actions are made public (usually in the form of corporate scandal), they are often the result of a decisive victory for one faction over another within the communist party.
GCC monarchies
- Saudi: Anti-corruption actions post-2015 fit into a broader pattern of elimination of dissent and concentration of power under the Crown Prince;
- Kuwait: Anti-corruption scrutiny in parliament invariably masks an underlying conflict between populist MPs (subject to re-election) and cabinet ministers (appointed, and often re-appointed, by the Emir);

Military-dominated democracies
- Egypt, Pakistan, Thailand: In each of these three political economies, the military persists as the dominant domestic political institution (and, in the case of Egypt, the dominant economic power). Civilian governments are generally junior partners in the military-civilian relationship. Anti-corruption measures have been used repeatedly as a means to discipline or weaken the junior civilian partner (and certainly applied much more publicly to civilian politicians than to military personnel).
- Egypt: Following the 2011 'Arab Spring', the break of up of the National Democratic Party of Hosni Mubarak and its associated commercial interests, which increasingly encroached on military-aligned commercial interests, included a witch-hunt of former government officials and private sector corporate leaders under the banner of anti-corruption. Egypt's Transparency International corruption score improved 15% between 2012 and 2014, before retracing all of that improvement by 2017 (it subsequently improved 10% by 2019).
- Pakistan: The national accountability drive under former President Musharraf following the military coup of 1999 briefly targeted civilian political leaders and their associated corporate interests but this was noticeably softened as Musharraf transitioned from the leader of a military coup to something more closely resembling a president (in the process, reconciling with increasing portion of the established civilian political class), and entirely abandoned by 2007 (crystallised by his attempt to pass a corruption amnesty for the established civilian political and bureaucratic elite, the National Reconciliation Ordinance).
- Thailand: Thaksin Shinawatra (PM from 2001-06) and Yingluck Shinawatra (PM from 2011-14) were both effectively removed from office in military coups, both opted for exile and both were convicted of abuse of power in absentia. Underlying these events was the schism in Thai politics that persists to the current day between political forces closer to the army, the monarchy, and the southern urban middle class (the "yellow shirts") and those closer to the urban working class, the north and north eastern farmer class (the "red shirts"). Thailand's Transparency International corruption scores have barely changed since 2012.
Wider Europe
- Georgia: Even in widely applauded cases of anti-corruption policies, the risk of back-sliding remains. Georgia is a good example of the vulnerability of reform gains. The transition of power from United National Movement (led by Saakashvili) to Georgian Dream (led by Ivanishvili) in 2012 was followed by anti-corruption reforms but those have given way recently to concerns that one version of state capture has given way to another. Georgia's Transparency International corruption score improved almost 20% between 2013 and 2018 before slipping by 5% in 2019. It remains to be seen whether constitutional reform agreed in 2020 will better secure the gains of the early years under Georgian Dream.

Pakistan exceptionalism

Our positive investment thesis on Pakistan is built on a view that a generational improvement in governance is underway, military-civilian relations are sustainably stable, infrastructure is undergoing an upgrade under CPEC (albeit expensively), relations with India cannot get worse because of the nuclear deterrent, FX rate valuation is fair and equity valuations are very cheap. The risks are that Covid-19 proves too big an economic shock and the succession to PM Imran Khan is uncertain.

Improving governance, where anti-corruption investigations, disclosures and enforcement are key elements, is a very bold call in the context of the arguments presented above. With such scepticism over how sincere and how effective anti-corruption agendas are in general, including military-dominated democracies, why the exceptional outlook for Pakistan? Three factors drive this.

Deep state: The military-intelligence deep state in Pakistan remains dominant in Pakistan's political economy but its priorities have had to change (for its own survival as much as that of the country): the US is not a reliable financial or diplomatic supporter (from a Pakistan perspective, China can partially replace financial flows but cannot match the export potential of the US), the integrity of Pakistan was at risk without the restoration of law and order, state assets have withered to such a degree that they have become liabilities, and sustainable gains in security and a path to sovereign financial independence is not possible without improving the economy. Anti-corruption is an essential part of both the security and economic challenges.
Grassroots politics: The Pakistan Tehreek Insaf (PTI) party, led by PM Imran Khan, has grown into a nationwide party with a diverse support base over two and half decades. While it just as reliant on cooperative relations with the military-intelligence deep state as every other precedent civilian government, it is not a recent political construction of convenience. Its value to the military-intelligence deep state is that it provides the most likely partner in tackling corruption and improving governance (because of the links with corrupt, vested interest networks with the previously dominant political parties – Nawaz Sharif's PMLN, Asif Zardari's PPP and Altaf Hussein's MQM – that are now likely in permanent decline).
International relations: China is now the international geopolitical partner of Pakistan. Unlike historical partners, the US and Saudi Arabia, there is an overlapping interest in the geographic integrity and economic progress of all of Pakistan. This is not out of altruism; China needs security across all provinces in Pakistan for its own physical supply routes. The coordination of rebel Mujahideen forces during the Soviet-Afghan War for the US or the provision of troops-on-demand and nuclear cover for Saudi, meant those international partners cared most about coherent leadership in the Pakistan military-intelligence agencies more than security or economic benefits across all provinces.

This type of positive structural change in governance, driven by the confluence of changes in the deep state, organic grassroots politics and international relations, is not underway anywhere else in the emerging markets universe.

Corruption is another ESG work-in-progress

The growth of environmental, social and governance (ESG) investing as, at least, a successful marketing pitch is undeniable. Whether it is sincerely or consistently implemented as an investment philosophy is a completely separate issue.

Corruption presents a thorny issue for ESG investing because of all of the issues highlighted above (the difficulties in measurement of corruption, its true economic impact and the policies to adopt in response, and the sincerity with which those policies are pursued) and also because of the connection between corruption in emerging markets and developed markets.

The majority (84%) of illicit financial flows from emerging markets are via fraudulent trade invoicing and, in turn, the majority of this trade is with developed economies. According to Global Financial Integrity, illicit financial flows in 2015-16 were equal to 20-30% of total trade between emerging and developed economies.

Do ESG investors discriminate against emerging markets because these markets typically score more poorly in third-party measures of corruption? If most of the gains from this corruption are destined for developed markets then this discrimination is perhaps without merit. Indeed, if a material share of illicit financial flows end up in offshore financial centres then how meaningful are indices of corruption where the governments regulating those offshore centres score so highly (eg Singapore, Switzerland, UK)?

To demonstrate the point, a revisit of the tragi-comedy of the London Anti-Corruption Summit in 2016, hosted by then UK Prime Minister David Cameron, is in order. Summarised in the quotes below are the diplomatic gaffe by Cameron and the response of attending Nigerian officials, including President Muhammadu Buhari, which alluded to the duplicity of financial institutions and real estate owners in developed markets which act as conduits and recipients of illicit financial flows.

“We have got the Nigerians – actually we have got some leaders of some fantastically corrupt countries coming to Britain.” David Cameron, Prime Minster of the UK in conversation with Queen Elizabeth II (May 2016)
“We need an international anti-corruption infrastructure that can monitor trace and facilitate the return of assets to the countries of origin. The repatriation of proven stolen assets should be done without delay or precondition.” Muhammadu Buhari, President of Nigeria (May 2016)
“It takes two to tango. The problem of this country [UK] is in receiving stolen assets, ill-gotten money, and keeping it here, and telling our country that they’re not doing the right thing is not the way to solve the problem.” Chukwuka Utazi, Senator and Chair of Nigeria Parliamentary Committee on Financial Crimes and Corruption (May 2016)

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