Impact of financial structure on environmental quality: evidence from panel and disaggregated data

ABSTRACT

This paper examines two unresolved issues regarding the nexus between financial system development and environmental quality. (i) Does the structure of the financial system matter? (ii) Is there a nonlinear relationship? We employ the newly developed dynamic common correlated effect (CCE) and the dynamic panel generalized method of moments (GMM) estimators in order to address potential endogeneity, heterogeneity and cross-sectional dependence in a panel of 58 countries. The panel data analysis reveals that the structure of the financial system matters in safeguarding environmental quality. More precisely, bank-based financial development enhances environmental quality, whereas the impact of market-based financial development is tenuous. We find some evidences of a nonlinear relationship between financial system development and environmental quality. The disaggregated data reveals the countries where financial structure matters for environmental quality, and countries where a nonlinear relationship exists between the variables. Therefore, countries that want to maintain environmental quality should strengthen the development of bank-based financial system. Moreover, effort to develop and reposition the stock markets should be prioritized in countries’ environmental policies with a view to sustaining environmental quality.

KEYWORDS:

• Economic growth
• environmental quality
• financial structure
• panel data

Notes

¹ We thank the anonymous reviewer for this comment. Empirical literature stressed the mechanisms through which financial development influences environmental quality. First, banking and stock market have the capacity to influence economic growth which requires greater energy consumption thereby worsening environmental quality (see Ahmed and Wahid 2011; Beck and Levine 2004; Dogan and Seker 2016; Kahia, Aissa, and Lanouar 2017; Zhang and Liu 2019; Zhang and Wang 2019). In addition, some empirical studies have showed that banking and stock market development influence energy consumption (e.g. Hao, Wang, and Lee 2018; Kakar 2016; Topcu and Payne 2017; Ulusoy and Demiralay 2017). Thus, banking development enhances environmental quality if it enables firms to adopt advanced energy-saving and cleaner technologies that are environmentally friendly. It could also enhance the funding of environmental projects at reduced costs and boosts foreign direct investment, which in turns stimulates technological improvements. However, banking development could worsen environmental quality if it increases the manufacturing activities that raise industrial pollution, and provides more credits or loans to consumers to purchase electrical appliances that produce carbon emissions. Similarly, stock market influences environmental quality by initiating environmental friendly policies (e.g. greener technologies in production and consumption to maximize energy efficiency) and ensure that all the listed firms in the stock exchanges adopt such policies in order to lessen carbon emissions.

² The countries include Argentina, Australia, Austria, Bangladesh, Belgium, Bolivia, Brazil, Bulgaria, Canada, Chile, China, Costa Rica, Côte d’Ivoire, Denmark, El Salvador, Finland, France, Germany, Ghana, Hong Kong, India, Indonesia, Iran, Ireland, Israel, Italy, Japan, Jamaica, Kenya, Korea Republic, Lebanon, Luxembourg, Malaysia, Mauritius, Mexico, Namibia, Netherlands, New Zealand, Nigeria, Norway, Oman, Pakistan, Panama, Peru, Philippines, Poland, Portugal, Romania, Singapore, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Thailand, Turkey, United Kingdom, and United States.

³ The results are not presented for want of space, but available upon request.

⁴ We agreed with the anonymous reviewer that panel data analysis (that combines developed and developing countries) may mask some vital country-specific results regarding the link between financial development and environmental quality. To address this issue, we complement the panel data analysis with country-specific estimates that reveal the impact of financial development on environmental quality in each of the 58 countries. An insight into where financial development enhances environmental quality, and where it does not, is fundamental for policy formulations.