INTRODUCTION
Research problems
The interplay between openness, financial development, economic growth, and environmental quality has garnered significant attention in economic literature over recent decades It is increasingly recognized that trade and financial openness serve as crucial mechanisms for fostering financial development, as highlighted by researchers such as Rajan & Zingales (2003), Baltagi et al (2009), and Chinn & Ito.
2002, 2006; Law & Demetriades, 2006; David et al., 2014; Svaleryd & Vlachos,
Economic growth in developing countries is significantly influenced by various factors, including trade openness, which plays a vital role in determining environmental quality Research indicates that understanding the interactions among these key elements is essential for fostering sustainable development in these economies.
Numerous studies have explored the relationship between financial development, economic growth, and environmental quality, primarily relying on traditional statistical methods for panel data analysis However, these standard approaches often overlook model uncertainty, resulting in overconfident inferences and biases that can distort findings The emergence of competitive theories and empirical studies in this field presents a significant challenge for development economics To address model uncertainty effectively, Bayesian model averaging (BMA) offers a robust solution by accommodating a wide range of candidate regressors This thesis advocates for the adoption of BMA, building on foundational works in the field.
Raftery et al (1997), Hoeting et al (1999), and other studies (2005) significantly contribute to bridging methodological gaps in development economics However, previous findings on the relationships between financial development, economic growth, and environmental quality remain inconclusive and contentious Section 1.1 outlines three key research issues: the effects of openness on financial development, the influence of financial development on economic growth, and the impact of trade openness on environmental quality.
Impacts of openness on financial development
The relationship between trade openness, defined as the ratio of total trade to GDP, and financial openness, which refers to the integration of international financial markets, significantly impacts financial development Rajan and Zingales (2003) propose the simultaneous openness hypothesis, asserting that both trade and capital account liberalization are essential for genuine financial development They argue that entrenched interest groups often resist financial development due to increased competition that threatens their profits; however, opening trade and capital flows can diminish their power and foster financial growth In contrast, McKinnon (1991) advocates that trade liberalization should occur prior to financial liberalization, particularly in developing nations Despite the intriguing premise of the simultaneous openness hypothesis, empirical evidence regarding the effects of openness on financial development is inconsistent, with studies yielding both positive and negative results across various economies This thesis aims to explore this topic further, focusing specifically on developing countries, where research remains limited.
In the last two decades, trade and financial liberalisation have significantly impacted developing countries, largely driven by structural adjustment policies imposed by international organisations like the IMF, World Bank, and WTO since the 1980s These policies have led to reduced trade barriers, deregulation, and privatisation, alongside the removal of financial repression, which has resulted in notable disparities in financial development between developing and developed nations While developing countries have experienced steady financial growth, developed economies have seen stagnation since 2009 Moreover, trends in trade and financial openness in developing countries have become increasingly unpredictable This thesis aims to investigate the critical roles of trade and financial openness in the financial development process of developing countries, considering the mixed findings of prior research.
Moreover, understanding the causes underlying financial development is crucial because it allows countries, especially developing ones, to encourage banking sector activities, which can affect economic growth
Source: Global Financial Development Database (GFDD) and author’s calculations
Figure 1.1 Financial development in developing countries over the period 2003-
Source: World Development Indicators (WDI), Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER),
Chinn and Ito (2019), and author’s calculations
Figure 1.2 Openness in developing countries over the period 2003-2017
This thesis enhances the empirical literature on openness and financial development by addressing six key aspects It employs a Bayesian Model Averaging (BMA) approach, building on foundational studies by Raftery and colleagues from 1993 to 2005.
This thesis addresses a gap in econometrics literature by examining model uncertainty in the context of openness and its effects on financial development, a topic previously unexplored It employs the ratio of private credit to GDP as a key indicator of financial development, particularly relevant for developing countries, amid ongoing debates about measurement methods Additionally, it highlights the lack of empirical research on how openness impacts financial development in these nations, specifically considering the legal origins variable that influences the protection of corporate shareholders and creditors The study further explores various interactions between trade openness and factors such as financial openness, institutional quality, and real GDP per capita, to reveal the diverse channels through which trade liberalization influences financial development Regional dummy variables are incorporated as control factors to enable comparisons of financial development across different regions Finally, utilizing data from 2003 to 2017 allows for a comprehensive sample of developing countries, enhancing the robustness of the findings compared to prior studies.
Impact of financial development on economic growth
The relationship between financial development and economic growth has been a key focus in development economics research for several decades, highlighting its significance in understanding economic progress (Andersen & Tarp, 2003; Chinn & Ito, 2002; Estrada et al., 2015; King).
Empirical studies indicate that financial systems significantly impact savings and investment decisions, fostering economic growth in both developed and developing nations Levine (2005) identifies five essential functions of financial systems: producing pre-investment information, monitoring investments and corporate governance, facilitating trade and risk management, mobilizing savings, and easing the exchange of goods and services The efficiency of a financial system is measured by its ability to perform these functions effectively, while financial development focuses on enhancing this efficiency.
Source: World Development Indicators (WDI) and author’s calculations
Figure 1.3 Economic growth in developing countries over the period 2003-2017
Over the past twenty years, developing economies have undergone significant financial sector reforms, driven by the removal of government-imposed restrictions on interest rates, reserve requirements, and credit allocation These changes aim to foster economic growth, as highlighted by the foundational work of McKinnon and Shaw.
Between 2003 and 2017, developing countries experienced significant fluctuations in their economies, with a notable period of rapid growth from 2003 to 2007 due to high financial development However, this growth was abruptly interrupted by a decline from 2007 to 2009, leading to a dramatic reversal in 2009 and subsequent stagnation in economic growth that persisted from 2010 to 2017 This thesis aims to explore the effects of financial development on economic growth in developing countries during this timeframe.
This investigation enhances the existing literature by addressing six key areas Firstly, it explores the under-researched relationship between financial development and economic growth in developing countries, particularly considering trade and financial openness Secondly, it utilizes Bayesian statistics, specifically the BMA approach, to analyze the impact of financial development on economic growth, filling a gap left by previous studies that primarily relied on traditional panel data methods Thirdly, it challenges the conventional measurement of financial development, which often uses the ratio of private credit to GDP, questioning its suitability for developing nations Fourthly, it highlights the lack of empirical research examining the role of legal origins in protecting corporate shareholders and creditors within developing economies Lastly, the thesis investigates various interactions between trade openness, financial openness, and institutional quality to understand the different channels through which trade liberalization may affect economic growth.
Finally, regional dummy variables are included in the regressions as control variables to compare the levels of economic growth across regions
Impact of trade openness on environmental quality
International trade plays a significant role in influencing environmental quality, as it can lead to increased pollution due to economic growth While some studies suggest that trade is a primary cause of environmental degradation, others argue that the environmental damage associated with trade is not directly caused by it The scale effect indicates that as trade volume increases, so does pollution, but trade can also improve environmental quality through the technique and composition effects The production of pollution-intensive goods may shift to poorer nations due to stricter regulations in wealthier countries, a phenomenon explained by the displacement and pollution haven hypotheses These hypotheses highlight that trade liberalization can accelerate the growth of pollution-heavy industries in developing countries However, trade can also facilitate technology transfer through foreign direct investment, potentially reducing environmental harm Thus, free trade has both positive and negative impacts on environmental quality.
Source: World Development Indicators (WDI) and author’s calculations
Figure 1.4 Environmental quality in developing countries over the period 2003-
Over the past two decades, rising greenhouse gas emissions have emerged as a major threat to global warming, raising concerns across both developed and developing nations Data indicates that CO2 emissions per capita are substantially higher in developed countries compared to their developing counterparts Notably, from 2003 to 2017, developing countries experienced a significant increase in CO2 emissions per capita, while developed nations saw a marked decline in this metric.
Research objectives
Trade and financial openness play a crucial role in enhancing the demand and supply of financial services, expanding market sizes, and diminishing the power of incumbents This increased transparency in the loanable funds market, driven by the price mechanism, can significantly impact financial development, economic growth, and environmental quality in developing countries Additionally, these factors may either reduce or increase environmental pollutants, highlighting the complex relationship between trade, finance, and sustainability.
This thesis aims to present new insights into how trade and financial openness influence financial development, the effect of financial development on economic growth, and the relationship between trade openness and environmental quality in developing countries The analysis is based on a sample of 64 developing nations from 2003 onwards.
2017 The thesis includes the following specific objectives:
(i) First objective: Investigating the impacts of trade and financial openness on financial development (Objective 1 henceforth);
(ii) Second objective: Investigating the impact of financial development on economic growth (Objective 2 henceforth);
(iii) Third objective: Investigating the impact of trade openness on environmental quality (Objective 3 henceforth).
Research contributions
This thesis significantly advances three key objectives by adopting a Bayesian Model Averaging (BMA) regression model, which effectively addresses model uncertainty more robustly than traditional frequentist statistics Additionally, it offers a comprehensive analysis of various competing theories related to financial development, economic growth, and environmental quality research.
This thesis presents three key contributions regarding the effects of openness on financial development First, it reveals that a strong institutional environment enables developing economies to fully leverage the advantages of openness for financial growth Second, it challenges the Rajan and Zingales hypothesis, finding no evidence that simultaneous openness to trade and capital flows enhances financial development, as indicated by the ratio of private credit to GDP in developing nations Lastly, it highlights the significance of legal origins in shaping financial development, demonstrating that the British legal system lessens the positive effects of openness compared to the French legal system, a perspective previously overlooked in related research.
This thesis presents three key insights into the relationship between financial development and economic growth Firstly, it offers new evidence illustrating a U-shaped curve effect of financial development, measured by the ratio of private credit to GDP, specifically in developing countries Secondly, it highlights the significant role of Socialist legal origins in enhancing economic growth, surpassing the impact of French legal origins, a topic that has not been previously explored in this context Lastly, the research confirms that effective population control measures could play a crucial role in fostering economic growth in developing nations.
The impact of trade openness on environmental quality reveals several key insights: Firstly, the findings offer partial support for the pollution haven hypothesis, particularly in relation to relative capital abundance in developing countries Secondly, this research diverges from the conclusions of Antweiler et al (2001) while building on the work of Cole and Elliott.
This thesis addresses the gap identified by previous studies (2003, Managi et al 2009) by incorporating financial openness and renewable energy consumption as key factors influencing environmental quality The findings strongly support the role of renewable energy consumption in significantly reducing CO2 emissions in developing countries Furthermore, it emphasizes that financial liberalization is a critical element in efforts to mitigate CO2 emissions in these regions.
Structure of the thesis
The remainder of the thesis is organized as follows
Chapter 2: This chapter reviews theoretical and empirical studies relating to three research objectives, including (i) the impacts of openness on financial development; (ii) the impact of financial development on economic growth; (iii) the impact of trade openness on environmental quality In addition, this chapter also provides the theoretical and conceptual frameworks and hypotheses
Chapter 3: This chapter includes the research approach of the thesis, the construction of variables, and the data source related to the three research objectives
Chapter 4: This chapter provides descriptive statistic summaries and BMA results of three research objectives with a sample of 64 developing countries during the period 2003-2017, including (i) the impacts of openness on financial development; (ii) the impact of financial development on economic growth; (iii) the impact of trade openness on environmental quality
Chapter 5: This chapter summarises some of the main findings of the thesis and explains policy implications, contributions, limitations, and suggestions for further research.
LITERATURE REVIEW
Openness and financial development
2.1.1 Impacts of openness on financial development: A theoretical review
The McKinnon-Shaw hypothesis, established by McKinnon and Shaw in the early 1970s, advocates for financial openness by arguing against financial repression policies such as interest rate ceilings, administrative credit allocation, and high reserve requirements These government-induced distortions, prevalent in less developed countries during the 1960s and 1970s, hinder economic growth and development.
Figure 2.1 The McKinnon-Shaw model
The McKinnon-Shaw hypothesis illustrates a positive correlation between savings and real interest rates across varying economic growth rates, as depicted in Figure 2.1.
Real rat e of in ter es t
In less developed countries, investment and saving are often impacted by a real interest rate that remains below its equilibrium level, resulting in an administratively set nominal interest rate Additionally, financial repression, characterized by a fixed interest rate, can increase savings while simultaneously limiting actual investment levels.
Establishing interest rate ceilings on loans leads to significant consequences for the economy Firstly, it results in low savings and investment levels, as savings are crucial for determining the real supply of credit Secondly, the allocation of investable funds becomes inefficient due to non-price rationing These factors hinder the growth and development of both the financial system and the overall economy.
When higher nominal interest rates are introduced, reducing financial repression positively impacts savings by increasing the real interest rate This change eliminates low-yield investments, thereby enhancing overall investment efficiency Additionally, economic growth improves, shifting the savings function, resulting in a higher actual investment rate due to increased savings.
The McKinnon-Shaw hypothesis advocates for the removal of interest rate ceilings in repressed financial systems during financial liberalization This approach is expected to enhance economic growth by increasing savings and the availability of loanable funds, leading to a more efficient allocation of resources The model suggests an equilibrium where the real interest rate stabilizes at r2, with savings and investment aligning at I2, as illustrated in Figure 2.1 Ultimately, this creates a transparent market for loanable funds driven by the price mechanism.
Beck (2002) presents a theoretical model highlighting the significance of financial development in facilitating large-scale, high-return enterprises, particularly in the context of trade openness This model suggests that economies with advanced financial systems enable producers to benefit from scale economies, leading to increased production and improved trade balances (Helpman, 1981; Khan, 2001) In a closed economy, Beck indicates that the share of entrepreneurs in manufacturing diminishes with higher search costs for financial intermediaries In contrast, lower search costs in the food industry yield lower returns for entrepreneurs compared to manufacturing, where scale efficiencies allow for greater earnings from external financing Consequently, financial development that reduces search costs shifts production incentives toward manufacturing To maintain equilibrium in an open economy, Beck argues that if domestic financial intermediaries face higher search costs than global counterparts, the economy will export food while importing manufactured goods This aligns with the Ricardian hypothesis, suggesting that a robust financial system fosters a technological edge in manufacturing, resulting in a comparative advantage in that sector.
In addition to Beck's (2002) theoretical model on financial development and international trade, which emphasizes the supply side, there are two primary direct channels through which openness influences financial development by enhancing demand for financial services and expanding market size Svaleryd and Vlachos (2002) found that increased trade openness generates demand for innovative financial products, such as trade finance instruments and risk hedging solutions Moreover, capital account openness can lower capital costs and boost liquidity, potentially resulting in greater financial development.
(2001) fined some evidence that the stock market liquidity may be improved by abolishing restrictions imposed on international portfolio flows
Openness significantly impacts financial development through political economy factors, as noted by Rajan and Zingales (2003) They argue that interest groups, or incumbents, oppose financial development due to the increased competition it fosters, which threatens their economic advantages The simultaneous opening of trade and capital flows can diminish the power of these incumbents, leading to enhanced financial development New opportunities created by trade and financial openness can generate profits that outweigh the negative effects of competition Additionally, Braun and Raddatz (2005) highlight that economies experiencing trade liberalization, which reduces the influence of groups resisting financial development, tend to improve their financial systems Conversely, external finance may decline if trade openness strengthens these opposing groups.
Numerous studies highlight a positive correlation between openness, institutions, and financial development Kose et al (2009) demonstrate that capital account liberalization can enhance macroeconomic policy discipline by amplifying the benefits of sound policies and the risks associated with weak ones Their findings indicate that financial openness is linked to improved monetary policy outcomes However, there is no evidence that trade and financial openness impose similar discipline on fiscal policy Mishkin (2009) notes that the influx of foreign capital facilitates technology transfer, prompting domestic banks to elevate their lending standards and embrace international best practices Conversely, openness may adversely impact financial development by increasing volatility and encouraging excessive risk-taking among domestic banks (Kose et al., 2009; Mishkin).
According to Stiglitz (2000), the success or failure of free trade and financial liberalization hinges on management practices Successful outcomes are observed when national governments tailor approaches to their unique contexts, as seen in East Asian nations like South Korea and Taiwan Conversely, reliance on international institutions such as the IMF, World Bank, and WTO often leads to failure Stiglitz advocates for "global governance without global government," emphasizing that in developing countries, hasty financial and capital market liberalization without a robust regulatory framework has been detrimental Notably, India and China have thrived amid global economic challenges due to their strong capital flow controls.
Figure 2.2 presents a theoretical framework that illustrates the impacts of openness on financial development
Figure 2.2 A theoretical approach to openness and financial development
2.1.2 Impacts of openness on financial development: An empirical review
Most studies have focused only on perspectives of the sources of financial development such as financial liberalisation (Chinn & Ito, 2002, 2006), legal systems
- Abolishing policies of financial repression (e.g interest rate ceilings, administrative credit allocation, high reserve requirements, and other government-induced distortions)
- Creating demand for financial services (e.g., trade finance instruments, hedging of risks)
- Decreasing in search costs for financial intermediaries
- Enhancing transparency of financial market via a price mechanism
- Encouraging domestic banks to adopt of international standards
How it is managed (Institutions)
Research has highlighted the significance of openness as a crucial factor in financial development, alongside institutions (Beck & Levine, 2005; Porta et al., 1998; Feng & Yu, 2020; Kutan et al., 2017) While existing literature has primarily examined the relationships between financial development and trade openness (Beck, 2002; Gries et al., 2009; Kim et al., 2010a, 2010b; Svaleryd & Vlachos, 2002), as well as financial openness (Chinn & Ito, 2002, 2006), the interplay involving all three variables remains underexplored (Aizenman & Noy, 2009; Baltagi et al., 2009; Rajan & Zingales, 2003) Although the effects of openness on financial development have garnered significant attention, empirical findings reveal mixed results, particularly when comparing developed and developing economies.
Recent studies have explored the connection between financial development and trade openness, with Beck (2002) examining this relationship specifically in the context of manufactured goods Utilizing ordinary least squares and instrumental variables estimations, the study investigates how the overall level of external finance influences the trade balance in manufacturing The empirical validity of this theoretical model is supported by panel data collected from 65 countries.
From 1966 to 1995, Beck (2002) posits that enhanced financial development correlates with increased export shares and improved trade balances in manufactured goods within countries boasting well-developed financial systems Additionally, Svaleryd and Vlachos (2002) explore the link between financial development and trade openness across 80 countries from 1960 to 1994, revealing that trade openness is associated with heightened risks, such as foreign competition and external shocks These risks can drive financial market development, which aids in risk diversification, enabling firms to better manage adverse shocks and short-term cash flow challenges Data from 32 manufacturing industries in 20 OECD countries from 1989 further supports these findings.
Research by Svaleryd and Vlachos (2005) indicates that financial development significantly impacts industrial specialization across 20 OECD countries, fostering export industries reliant on finance Kim et al (2010a) reveal that while trade openness correlates positively with financial development in the long run for both high- and low-income nations, this relationship is negative in the short term Additionally, Kim et al (2010b) highlight a long-term complementarity between trade openness and financial development, contrasting with short-term substitution effects in non-OECD countries Wolde-Rufael (2009) finds that in Kenya, financial development supports both import and export growth, although the reverse causality from trade to finance is weak Gries et al (2009) analyze 16 Sub-Saharan African nations and conclude that the relationship between trade openness and financial development varies significantly, suggesting that trade may enhance financial depth in certain contexts Do and Levchenko (2007) propose that the demand for external finance is a key factor in determining a country's financial development, influenced by its comparative advantage in international trade, leading to increased financial intermediation in economies specializing in finance-dependent goods, while those focusing on less finance-dependent goods experience slower financial growth.
Financial development and economic growth
2.2.1 Impact of financial development on economic growth: A theoretical review
Economists assert that financial systems play a crucial role in shaping savings and investment decisions, ultimately driving economic growth (Levine, 2004; Zhuang et al., 2009) Levine (2005) highlights that financial systems in emerging markets serve to minimize information, enforcement, and transaction costs The five fundamental functions of these systems include: (i) generating pre-investment information and allocating capital; (ii) monitoring investments and enforcing corporate governance post-financing; (iii) facilitating risk trading, diversification, and management; (iv) mobilizing and pooling savings; and (v) simplifying the exchange of goods and services Consequently, the efficiency of a financial system is measured by its ability to perform these core functions, with financial development signifying enhancements in this efficiency.
Financial systems play a crucial role in generating pre-investment information and allocating capital effectively Individual savers often encounter significant costs when gathering and analyzing information about firms, managers, and market conditions, which can hinder optimal capital allocation (Bagehot, 1873) Financial institutions mitigate these costs by streamlining the information collection and processing, thereby enhancing resource allocation and promoting economic growth through specialization and economies of scale (Allen, 1990; Bhattacharya & Pfleiderer, 1985; Boyd & Prescott, 1986; Ramakrishnan & Thakor).
Improved information plays a crucial role in helping entrepreneurs identify optimal production technologies and successfully launch new products and processes (King & Levine, 1993b; Acemoglu & Zilibotti, 1997; Acemoglu et al., 2006) Schumpeter (1912) highlights the importance of bankers as facilitators of innovation, enabling individuals to innovate on behalf of society Additionally, stock markets contribute to the dissemination of information about companies, encouraging investment in research as larger and more liquid markets provide better opportunities for profit (Grossman & Stiglitz, 1980; Holmström & Tirole, 1993; Kyle, 1984).
Financial systems play a crucial role in monitoring firms and enforcing corporate governance, which is vital for economic growth As Levine (2004) highlights, the ability of shareholders and creditors to oversee and influence capital usage is essential for maximizing corporate value and effectively allocating resources Strong corporate governance mechanisms can alleviate the "agency problem" that arises from the separation of equity and debt holders from managers (Coase, 1937; Meckling & Jensen, 1976; Myers & Majluf, 1984) Consequently, effective corporate governance enhances firm efficiency in resource allocation and utilization, encouraging savers to invest in innovation and production.
Financial instruments, intermediaries, and markets play a crucial role in accelerating trading activities, hedging, and risk pooling, thereby reducing risks associated with various entities such as countries and industries The effectiveness of the financial system in providing risk diversification services is vital for long-term economic growth, as it encourages saving and enhances resource allocation By facilitating cross-sectional risk diversification, financial systems can also foster technological innovation despite the inherent risks of innovative activities Moreover, the ability to manage a diverse portfolio of creative projects mitigates risk and promotes investment in growth-oriented endeavors Additionally, financial systems support intertemporal risk sharing among generations, enhance liquidity, and promote long-term investment, ultimately driving economic growth.
Financial systems play a crucial role in mobilising and pooling savings from various individuals for investment purposes This process involves overcoming transaction costs and informational asymmetries, making it essential for economic development Effective financial systems that efficiently aggregate individual savings can enhance overall savings rates, leverage economies of scale, and address investment indivisibilities By facilitating the mobilization of funds from a diverse group of savers into a diversified portfolio of risky projects, these systems enable the reallocation of investments towards higher-return activities, ultimately fostering economic growth.
2004, p.880, as cited in Acemoglu and Zilibotti, 1997)
Financial institutions and markets play a crucial role in fostering specialization, technological innovation, and economic growth by minimizing transaction costs Unlike barter systems, which are expensive due to the need for extensive product knowledge, financial systems streamline the trading of goods and services Innovations in finance help reduce both transaction and information costs, facilitating increased specialization and efficiency As highlighted by Levine (2005), greater specialization necessitates more transactions, which in turn fuels further specialization Consequently, markets not only enhance exchange but also drive productivity improvements, creating a positive feedback loop that supports the development of the financial sector and overall economic advancement.
As developed by Levine (2004), Figure 2.4 shows a theoretical framework for the impact of financial development on economic growth
Figure 2.4 A theoretical approach to financial development and economic growth
2.2.2 Impact of financial development on economic growth: An empirical review
Numerous studies have explored the relationship between financial development and economic growth using various econometric methods, including cross-sectional, time series, and panel data analyses at both international and country levels Despite the extensive research conducted by scholars such as Beck et al and Levine, the results remain inconsistent Additionally, the complex and multifaceted nature of financial development adds to the challenges in establishing a clear link between it and economic growth.
- Producing information and allocating capital
- Monitoring firms and exerting corporate governance
Economic growth is one of the most critical explanations for the conflicting results of the impact of financial development on economic growth
Numerous studies indicate a strong positive relationship between financial development and economic growth across both developed and developing countries King and Levine (1993) found a significant correlation between financial depth and economic growth in 77 countries from 1960 to 1989 Levine and Zervos (1998) highlighted the importance of banking development and stock market liquidity in promoting output growth and productivity in 47 countries during 1976-1993 Further research by Levine et al (2000) using GMM estimators confirmed a positive link between financial intermediation and economic growth in 71 countries from 1960 to 1995 Calderón and Liu (2003) established that financial development drives real GDP per capita growth in 109 countries from 1960 to 1994 Beck and Levine (2004) reaffirmed the positive influence of stock market and banking development on economic growth in a study of 40 countries from 1976 to 1998 Estrada et al (2010) found that financial development significantly boosts economic growth in both developed and developing Asian countries from 1990 to 2008 Bangake and Eggoh (2011) identified a long-term equilibrium between financial development and GDP per capita, indicating bidirectional causality in 71 countries from 1960 to 2004 Bittencourt (2012) supported the Schumpeterian view that financial development fosters entrepreneurship and growth in four Latin American countries from 1980 to 2007 Caporale et al (2014) noted limited effects of stock and credit markets on growth in ten new EU members from 1994 to 2007, while a more efficient banking sector could enhance growth Lastly, Valickova et al (2015) conducted a meta-analysis of 1,334 estimates from 67 studies, concluding that stock markets accelerate economic growth more rapidly than other financial intermediaries.
Research on developing economies reveals a positive correlation between financial development and economic growth Al-Yousif (2002) conducted a Granger causality test within an error correction framework, analyzing data from 30 developing countries between 1977 and 1999 The study found that the relationship between financial development and economic growth is bidirectional, though it varies by country and is influenced by the financial development proxies employed Additionally, Kargbo and Adamu utilized the autoregressive distributed lag (ARDL) approach to further explore this relationship.
Research has consistently shown a positive relationship between financial development and economic growth across various countries and time periods A study by (2009) focused on Sierra Leone from 1970 to 2008, revealing that financial development enhances economic growth primarily through investment channels Similarly, Zhang et al (2012) analyzed data from 286 Chinese cities between 2001 and 2006, finding a significant positive association between financial development and economic growth using system GMM estimators In Kenya, Uddin et al (2013) employed the Cobb-Douglas production function and the ARDL bounds test from 1971 to 2011, concluding that financial sector development positively influences economic growth Lastly, Adu et al (2013) explored Ghana's financial development from 1961 to 2010 using the ARDL model, highlighting that the impact of financial development on economic growth varies depending on the indicators utilized.
Secondly, several other studies claim the existence of a threshold impact of financial development on economic growth For instance, Cecchetti and Kharroubi
Research indicates an inverted U-shaped relationship between the size of the financial sector and productivity growth, suggesting that beyond a certain point, increased financial development may hinder real economic growth Financial sector expansion can compete with other economic sectors for limited resources, leading to diminished productivity Arcand et al (2015) highlight a negative finance-growth correlation in high-income countries when private sector credit exceeds 100% of GDP, supporting the "vanishing effect" hypothesis of financial development This phenomenon is not attributed to factors such as institutional quality or banking crises Rioja and Valev (2004a) identify a threshold effect, noting that financial development positively influences economic growth only after reaching a specific level Their findings reveal that while financial development significantly boosts growth in economies with intermediate levels, its impact diminishes in highly developed financial systems and is negligible in less developed economies Shen and Lee (2006) also observe an inverse U-shaped relationship, and Law and Singh (2014) further confirm the existence of a finance threshold in the finance-growth nexus across 87 countries from 1980 to 2010.
Previous studies reveal varying relationships between financial development and economic growth across different income levels Rioja and Valev (2004b) found an insignificant link in low-income economies, a significant positive relationship in middle-income economies, and a weakly significant connection in high-income economies In contrast, De Gregorio and Guidotti (1995) and Huang and Lin (2009) argue that the positive impact of financial development on economic growth is less significant in high-income economies compared to low- and middle-income ones This presents a contradiction in understanding the link between financial development and economic growth at various income levels, as well as the nonlinear relationship involved Estrada et al (2015) utilized the Arellano-Bond GMM approach to analyze 108 countries from 1977 to 2011, including 20 developing Asian economies, and concluded that financial system development significantly contributes to economic growth, with a more pronounced effect in developing countries than in advanced economies.
Some studies challenge the link between financial development and economic growth Lucas (1988) emphasized that the significance of financial matters is often overstated in discussions Research by Kar et al (2011) on 15 Middle Eastern and North African countries from 1980 to 2007 revealed no bidirectional causality between financial development and economic growth Similarly, Menyah et al (2014) examined data from 21 African countries between 1965 and 2008 using a panel bootstrapped Granger causality approach, finding no evidence that financial development or trade liberalization contributes to economic growth, nor any causality between financial development and real GDP per capita.
Appendix 2.2 summarises systematic reviews of the impact of financial development on economic growth
2.2.3 Impact of financial development on economic growth: Research hypothesis and a conceptual framework
The thesis posits that there exists a threshold level of financial development that significantly influences the relationship between finance and economic growth in developing countries, as supported by the arguments and empirical evidence discussed in Appendix 2.2.
H 2 : The impact of financial development on economic growth is presented as an inverted U-shaped curve
Based on the research hypothesis H2, Appendix 2.2, and Section 3.2.2.2 for controlled variables, the conceptual framework of the impact of financial development on economic growth is demonstrated in Figure 2.5
Notes: (+), (-), (+/-), and (*) denote positive effect, negative effect, positive or negative effect, and interacted factors, respectively
Figure 2.5 A conceptual framework for the impact of financial development on economic growth
Trade openness and environmental quality
2.3.1 Impact of trade openness on environmental quality: A theoretical review
Consumption and international trade are interconnected, particularly as structural changes in production occur (Arrow et al., 1995; Stern et al., 1996; Ekins, 1997; Rothman, 1998) These production changes do not align with equivalent shifts in consumption patterns in developed countries, leading to the environmental Kuznets curve, which suggests that pollution-intensive industries tend to migrate from developed nations with strict environmental regulations to less developed countries with more lenient oversight (Copeland & Taylor, 1995) Additionally, the composition of trade in manufactured goods reflects the energy consumption of a nation, indicating a positive correlation between energy use and exports of manufactured products (Agras & Chapman, 1999; Suri & Chapman).
Rich economies often become net importers of pollution-intensive goods, while poorer economies tend to export these goods, as noted by Saint-Paul (1994) This phenomenon can be illustrated by an inverted-U curve, suggesting that wealthier nations specialize in "clean" and service-oriented industries, whereas poorer nations focus on "dirty" and material-heavy industries, without significant changes in consumption patterns (Cole et al., 2001; Jọnicke et al., 1997; Stern et al., 1996) Consequently, environmental impacts are transferred between nations rather than reduced, supporting the displacement hypothesis (Rothman, 1998) Furthermore, this hypothesis posits that trade liberalization may accelerate the growth of pollution-intensive industries in developing countries, as affluent nations impose stricter environmental regulations (Harrison, 1995; Rock, 1996; Tobey, 1990).
Trade liberalization can enhance environmental quality by increasing real income in poorer economies, which often leads to a demand for stricter environmental protections However, it also raises concerns about the pollution haven hypothesis, where heavily polluting industries relocate to countries with weaker environmental regulations, potentially harming the environment This hypothesis suggests that lax environmental standards can create a comparative advantage, resulting in a shift of dirty industries from developed nations with stringent regulations to developing countries Thus, while trade openness can promote cleaner environments in wealthier nations, it may inadvertently encourage pollution in less regulated regions.
Lowering environmental standards to attract foreign direct investment (FDI) can create pollution havens in developing countries These nations often rely on FDI for technology transfer, which can lead to the adoption of cleaner and more efficient energy technologies that reduce pollution However, the increasing global eco-awareness and the intertwining of trade, investment, and environmental issues pose a risk of disrupting these capital flows.
Figure 2.6 A theoretical approach to trade openness and environmental quality
Displacing production of dirty industries from developed countries to less developed countries
- Increasing demands for stricter environmental protection
- Migrating pollution-intensive goods industries to nations with weaker environmental standards
Reducing environmental pollution via technology transfer
- Suffering higher regulatory and supervision costs of environmental pollution in developed countries
- Reallocating of international capital impose developed country governments to relax environmental requirements
- Triggering the environmental “race to bottom”
- Enhancing environmental quality via an increase in employment and income
The "race to the bottom" scenario occurs when stringent environmental regulations in developed countries lead to high compliance costs for polluters, as highlighted by Jaffe et al (1995) and Mani and Wheeler (1998) This situation creates a strong incentive for heavily polluting industries to relocate to less regulated economies, resulting in capital outflows from developed nations Consequently, governments may feel pressured to relax environmental standards, potentially flattening the environmental Kuznets curve and escalating pollution levels, as noted by Dasgupta et al (2002).
Trade liberalisation and technological innovation are essential for sustaining economic growth and maintaining real income in developed economies Continuous innovation is necessary to prevent economic latecomers from needing the same energy and material inputs per unit of GDP as older industrialised nations Free trade facilitates the diffusion of clean technology, which may enable less developed economies to navigate the environmental Kuznets curve effectively.
Globalisation can lead to an environmental race to the bottom due to heightened competition for investments and jobs, as noted by Wheeler (2001) However, it can also enhance environmental quality in less developed countries by boosting employment and income through increased investments Therefore, globalisation is often aligned with pollution reduction efforts.
Economic globalisation is a key driver of global economic growth, yet its benefits remain a topic of debate The interplay between globalisation, liberalisation, and economic openness raises significant concerns, particularly regarding the market-oriented reforms embraced globally and their impact on environmental protection.
Figure 2.6 illustrates a theoretical framework for understanding the channels through which trade openness impacts environmental quality in developing countries
2.3.2 Impact of trade openness on environmental quality: An empirical review
Numerous empirical studies over the past few decades have employed various statistical and econometric models to explore the link between trade openness and environmental indicators such as CO2 emissions, SO2 emissions, fossil fuel usage, and greenhouse gases Despite these efforts, the results have shown significant inconsistencies.
Trade openness significantly enhances environmental quality, as demonstrated by Antweiler et al (2001), who analyzed 43 countries from 1971 to 1996 and found that increased trade reduces SO2 concentrations, indicating lower environmental degradation Similarly, Atici (2009) examined the relationship between GDP, energy use, and trade openness on CO2 emissions in Central and Eastern European countries from 1980 to 2002, revealing evidence of the environmental Kuznets curve (EKC), where rising GDP correlates with decreasing CO2 emissions over time This research suggests that globalization, through trade openness, does not elevate CO2 emission levels in the region.
Trade openness negatively impacts environmental quality, as evidenced by Managi (2004), who analyzed a panel dataset of 63 countries from 1960 to 1999, revealing that trade liberalization harms the environment Although income growth may mitigate some environmental degradation, Ang (2009) found that in China, CO2 emissions are adversely linked to technology transfer and research intensity, while positively correlating with energy use, income, and trade openness Additionally, Chebbi et al (2011) employed cointegration techniques to explore the short- and long-run relationships between trade openness, real GDP per capita, and CO2 emissions.
Trade openness in Tunisia from 1961 to 2004 has been shown to have a positive direct effect on CO2 emissions in both the short and long run, although it also results in a negative indirect effect over time This emphasizes the necessity for trade reforms to be accompanied by robust environmental policies Research by Le et al (2016) using cross-country panel data indicates a significant long-run relationship between trade openness and particulate matter emissions, suggesting that increased trade can lead to environmental degradation, particularly in middle- and low-income countries, while high-income nations experience a less harmful impact Similarly, Shahbaz et al (2016) utilized panel cointegration tests on data from 105 countries and found that trade openness generally reduces environmental quality, though the extent of this impact varies significantly across different income groups.
Numerous studies indicate that trade openness impacts environmental quality differently across developed and developing economies, as well as various environmental indicators For instance, Cole and Elliott (2003) found evidence supporting both the pollution haven and factor endowment hypotheses concerning CO2 and SO2 emissions, while results for biochemical oxygen demand (BOD) and nitrogen oxides (NOx) emissions were inconclusive They noted that trade liberalization could reduce BOD emissions per capita, but its effects on SO2 emissions were uncertain; however, a positive relationship was observed between trade liberalization and NOx and CO2 emissions Additionally, they suggested that trade liberalization might lower pollution intensity across all four pollutants Frankel and Rose (2005) examined trade's endogeneity and found that trade significantly reduces air pollution, particularly SO2 and moderate NO2 emissions, although evidence for particulate matter was lacking They concluded that trade does not appear to harm the environment Furthermore, Managi et al (2008) used instrumental variables to assess the overall impact of trade openness on environmental quality, revealing that while trade benefits OECD countries in the long term, it negatively affects SO2 and CO2 emissions in certain non-OECD countries, despite reducing BOD emissions.
Trade openness influences emissions through environmental regulation and capital-labor dynamics Managi et al (2009) re-examine the trade-environment relationship for OECD and non-OECD countries regarding SO2 and CO2 emissions, finding that trade openness may positively impact the environment in OECD nations, aligning with Cole and Elliott (2003) Conversely, Baek et al (2009) indicate that trade and income enhance environmental quality in developed economies, while negatively affecting it in most developing countries, where dirty industry migration raises concerns about pollution burdens Choi et al (2010) analyze CO2 emissions in China, Korea, and Japan from 1971 to 2006, revealing varying environmental consequences and the existence of the Environmental Kuznets Curve (EKC) based on national characteristics Japan exhibits a U-shaped curve, while China shows an N-shaped curve, with differing relationships between CO2 emissions and openness Mutascu (2018) explores the comovement of CO2 emissions and trade openness in France from 1960 to 2013, finding no short-term comovement but a long-term interaction driven by the business cycle Additionally, Nasir and Rehman (2011) investigate the connections among CO2 emissions, energy consumption, income, and foreign trade in Pakistan.
From 1972 to 2008, a study utilizing Johansen’s cointegration method found a quadratic long-run relationship between CO2 emissions and income in Pakistan, supporting the Environmental Kuznets Curve (EKC) hypothesis The research also indicated that foreign trade and energy consumption positively influence emissions, although no short-run evidence for the EKC hypothesis was found Similarly, Atici (2012) analyzed CO2 emissions and trade interactions in ASEAN countries from 1970 to 2006, revealing an inverted S-shaped curve for emissions, with exports significantly impacting CO2 levels The study concluded that foreign direct investment (FDI) does not enhance environmental quality, and while Japan's imports from ASEAN do not contribute to pollution, imports from China may increase per capita pollution levels.
An integrated conceptual framework for the links between openness, financial development, economic growth, and environmental quality in developing countries
financial development, economic growth, and environmental quality in developing countries
Figure 2.8 illustrates a comprehensive conceptual framework that highlights the interconnections among openness, financial development, economic growth, and environmental quality, grounded in both theoretical and empirical research, alongside five previously stated hypotheses aimed at achieving three key objectives.
The integrated conceptual framework illustrates the relationship between openness, financial development, economic growth, and environmental quality in developing countries Specifically, trade openness and its interaction with financial openness positively influence financial development, as indicated by the H1A and H1C channels However, trade openness may negatively impact environmental quality through the H3 channel Additionally, the H1B channel highlights that financial openness can have both positive and negative effects on financial development, which may subsequently exhibit an inverted U-shape effect on economic growth.
Notes: (+), (-), and (+/-) denote positive effect, negative effect, and positive or negative effect, respectively
Figure 2.8 An integrated conceptual framework for three objectives