The global economy depends on a reliable functioning of stock markets for capital accumulation and investment. However, stock markets can become dysfunctional due to various restrictions and impose transaction costs on private investment activities (Acemoglu and Verdier, 2000). These costs can be reduced by lowering corruption in the country and thereby improving market efficiency. This article contributes to literature by investigating the impact of political instability and lower control of corruption on stock market performance in Pakistan. Using panel data from 1995 to 2014, we find that corruption has a negative effect on stock market returns. We use GMM estimation techniques to test robustness of our findings. Our interaction effects show that bureaucratic quality mitigates the ill effects of corruption and increases stock market returns by decreasing red tape, while a distorted law and order environment reduces stock market returns.
Corruption involves bribing tax inspectors, pleasing powerful officials and spending money on entertainment to build networks and thus gain advantage in the investment sector. This activity increases share prices by over-inflating the firm’s value and creates speculative bubbles. When the bubble burst, investors lose their confidence and sell their shares. The resulting loss of investor confidence causes the stock market to crash, which leads to recession and economic stagnation.
Previous studies examine the effect of corruption on stock market performance, but they ignore the heterogeneous impact of individual institutional aspects. Our results indicate that institutional heterogeneity matters in determining the impact of corruption on stocks: Democratic accountability (DA) interacts with corruption: democracy initially increases corruption opportunities, but at a certain point it starts to mitigate corruption through economic liberalization and governance institutions (Rock, 2009). Bureaucratic quality also interacts with corruption: efficiency in government practices improves stock market returns, whereas a distorted rule of law lowers stock market returns.