Don't Drink The Water: The Corruption Index

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The following post is by a hedge fund manager friend of DB who shall remain nameless. He runs the emerging markets desk at his firm.
The man who first hired me to work in emerging markets investing used to claim that understanding the idiosyncrasies of these markets was entirely a matter of understanding corruption. Predicting policy choices, he argued, was a matter of figuring out which domestic interest would pay the highest bribes. Capital flight? Just a question of how corrupt actors were feeling about the security of their ill-gotten gains. At the time, my youthful enthusiasm resisted accepting wholeheartedly such a cynical conclusion. It wouldn't be unfair to say that a good deal of my many years of practical education since then has consisted of coming to a full understanding of my old boss's dictum. It turns out that countries run by crooks tend to blow up. Go figure.

Today marked the release of Transparency International's annual Corruption Perceptions Index. The index isn't a perfect measure, as corruption is a labile concept, but TI's methodology seems well thought-out, incorporating data derived from resident and non-resident country experts as well as business leaders. Readers can get further details on the index here.
The development of the sovereign CDS market means that more countries than ever before have observable credit spreads. As a result, it is possible to look at the relationship between CPI score and credit spreads for a large sample. Of the 180 countries evaluated by TI, there is CDS spread data available for 64. Take a look at the results: corruption matters.*

That one can very clearly illustrate the fiscal cost (via higher borrowing costs) of corruption would suggest one motive - though hardly the only or most obvious one - for a country to clean up its act. Why hasn't it happened already? Consider my old boss's dictum. Corruption makes sense for the corrupt. The burden of higher borrowing costs falls on the great mass of citizens. The fruits of corruption accrue to... the corrupt!
Scrutiny of the outliers seems to support the basic story. The biggest underperformers of their CPI score (i.e. higher credit spreads than expected) fall into two groups: the very highest-spread countries (foremost Argentina and Ukraine) and a couple of low-spread countries (Iceland and Latvia). The former group's outlier status appears to arise from the fact that even using log of spreads and a quadratic term doesn't fully capture the non-linearity of the relationship. The latter were prominent victims of the credit bubble, whose very tight sovereign credit spreads have blown out due to the actual or contingent sovereign liability for the banking system's losses. The biggest outperformers of their CPI score are actually not outperformers by much - residuals here are much smaller - with Philippines and China at the top of the list. Perhaps DB's commenters would care to tender some possible explanations for these two...