Financial instability and environmental degradation: a panel data investigation

Abstract

ABSTRACT Economic theory suggests several channels through which financial instability might influence environmental quality. However, the empirical testing of this nexus comprises only few studies with conflicting outcomes on both the presence as well as the direction of this relationship. This study aims to fill this gap by analysing the relationship between pollution emissions, financial instability, output growth, trade openness, gross fixed capital formation and foreign direct investment (FDI) using a large sample of 88 developing economies for the 1980–2014 period. For our short- and long-run estimates, we use the panel vector error correction model (P-VECM) and the panel cointegration method. Our outcomes support the presence of long-run relationships between the selected variables. Moreover, the income, trade openness, investment and financial instability variables augment carbon dioxide (CO2) emissions, whereas FDI reduces the latter. The vector error correction model (VECM) models show a bidirectional, short-run connection between income and environmental degradation. Our empirical findings have some important policy implications for developing countries.