Negative Alchemy? Corruption, Compositions of Capital Flows, and Currency Crises

Crony capitalism and self-fulfilling expectations by international creditors are often suggested as two rival explanations for currency crisis. This paper examines a possible linkage between the two that has not been explored much in the literature: corruption may affect a country’s composition of capital inflows in a way that makes it more likely to experience a currency crisis that is triggered/aided by international investors’ self-fulfilling expectations. We find robust evidence that poor public governance is associated with a higher loan-to-FDI ratio. Such composition of capital flows has been identified in the literature as being associated with a higher incidence of a currency crisis. There is also some weaker evidence that poor public governance is associated with a country’s inability to borrow internationally in its own currency. The latter is also associated with a higher incidence of a currency crisis. Therefore, the paper illustrates a particular channel through which crony capitalism can increase the chance of a currency/financial crisis even though it may not forecast the timing of the latter.