India and Pakistan are two countries with great potential that has attracted the interest of foreign investors. But it will likely remain potential until they address an old problem: corruption and crony capitalism, which raises the cost of doing business in both countries.

CountryCorruption Index in 2010Corruption Index in 2015
China78/16883/168
Hong Kong1317
Pakistan143117
India8776
Estonia2623
Denmark11
Finland42
USA2216

Source: Transparency International

Index/Fund12-month Performance
Global X MSCI Pakistan (NYSE:PAK)16.90%
iShares S&P India 50 (NASDAQ:INDY)6.16%
iShares MSCI Emerging Markets  (NYSE:EEM)

 

10.67%

 Source: Yahoo. Finance 9/30/2016

To be fair, both countries have made some progress in fighting corruption, as confirmed by the corruption index. And that has helped equities in both markets book hefty gains.This is especially the case for Pakistan’s market, which has been among the top performing frontier markets in recent years.

Still, the persistence of corruption may have a big backlash against economic reforms, as it was the case with parts of East Asia and Latin America in the 1990s. “Under the current regime of drift in India, crony capitalism has become real worry,” writes Ruchir Sharma inBreakout Nations. “Widespread corruption is an old problem, but the situation has now reached a stage where the decisive factor in any business deal is the right government connection. India is approaching the point that Latin America and parts of East Asia hit in 1990s, when a backlash started to form against economic reforms because any opening up of the economy was seen to favor just a select few.”

The continuation of the government’s role as a “license Raj” can perhaps explain the lack of investment growth, which worries LIU Post Professor Udayan Roy.

“India has grown at a nice 7 percent annual rate lately. But there are some worrying signs. First, private-sector investment has grown very slowly. That is, India’s businesses are not investing in new projects or in the expansion of existing projects. Perhaps this is because they are worried about India’s future.”

How can India and Pakistan fight corruption?

They certainly cannot fight corruption with corruption, ie by inviting foreign acquires from countries with high corruption. An example of this is the Karachi Electrics acquisition by Shanghai Electric — China is more corrupt than India and Pakistan.

But they can fight corruption by inviting investments from countries with low corruption rates — like Denmark, Finland, and Estonia-see table.

Even better, they can send Pakistani and Indian government bureaucrats to these countries to learn how to fight corruption.

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