This study aims to decompose financial development into its three key components (depth, access and efficiency) to investigate whether they can help to overturn the negative impact of foreign direct investment (FDI) on the environment.
The study uses a dynamic panel of 43 economies from 1982 to 2018 and decomposed financial development into its three key components: depth, access and efficiency.
The results from the various estimations indicate that financial deepening and efficiency reduce environmental risk and can overturn the negative impact of FDI on the environment. In addition, the study finds that low levels of financial access worsen environmental risk but doubling financial access is likely to reduce it which makes the relationship between access and environmental risk non-monotonic. After splitting the data set into high and low financially developed economies, the study reports that FDI is more environmentally depressive among low financially developed economies.
The practical implications are that improvement in financial efficiency guarantees high returns on savings and investment and can reduce environmental risk. So, central governments should invest in financial technologies and formulate financial regulations through monetary and fiscal policies to enhance financial efficiency and depth.
If inward FDI to Africa continues the business-as-usual trend, the environmental risk in the region may continue to rise, environmental conditionalities for FDI must be strengthened.
The study uses a comprehensive measure of financial sector development and decomposes financial development indicators to assess their efficacy in mitigating the relationship between FDI and environmental quality.
