Examining the direct and indirect effects of financial development on CO2 emissions for 88 developing countries

The previous literature presents conflicting outcomes on the relationship between financial development and CO2 emissions. This study fixes this puzzle by testing both the direct and indirect effects of financial development on environmental pollution using Environmental Kuznets Curve (EKC) framework. Our empirical investigation relies upon difference and system generalized method of moments for a large sample of 88 developing countries during 2000-2014 period. The estimated outcomes, based on five different indicators of financial development, support the pollution inhibiting role of financial development for the selected countries. We also validate the existence of EKC hypothesis for the panel of economies. More importantly, the results of the indirect channels show that financial development also reduces the adverse effects of income, trade openness and FDI on the pollution emissions. Further, the validity of pollution heaven hypothesis (PHH), tested through trade openness and FDI variables, is also contingent upon the existence of weak financial structure. When financial development traverses certain limits, PHH ceases to exist for both these variables. Lastly, population size augments pollution emissions while human capital reduces the later. Based on these results, we propose some very important policy implications for the sample economies.

Automated summary

This study addresses the conflicting outcomes in previous literature on the relationship between financial development and CO2 emissions. It finds that financial development plays a pollution inhibiting role in developing countries and validates the existence of EKC hypothesis. Additionally, financial development reduces the adverse effects of income, trade openness, and FDI on pollution emissions.