The Role of Financial Sector Development in the Relationship between Environmental Risk and Foreign Direct Investment

In recent years, environmental problems have attracted the attention of many policymakers. In many developing countries, foreign direct investment and environmental risk play a vital role for economic growth and development. Therefore, it is necessary to examine the relationship between foreign direct investment and environmental risk. In this regard, the present study examines the role of financial development in the relationship between foreign direct investment and environmental risk.

In the present study, the stationary ​​of the variables was first evaluated by using the ADF test and then by applying Kao cointegration, the long-run relationship between the variables of the model has been examined. Finally, the effect of financial development, foreign direct investment, GDP per capita and urbanization on environmental risk for 35 countries during the period of 1990-2021 was investigated using generalized panel moments. For the analysis and estimation of the model, Eviews_12 software has been used.

According to the ADF unit root test, some variables are stationary at the level and some are stationary at the first order difference, to avoid false regression in estimations, co-accumulation between variables was investigated. The results of the Kao cointegration test confirmed the long-term relationship between the variables. Also, the results of generalized method of moments model show that foreign direct investment has a negative and significant effect on environmental risk. Most foreign direct investment comes from developed countries with strict environmental regulations; hence, they can transfer superior environmental technologies to the host country. Finally, foreign direct investment paves the way for promoting environmental sustainability in the host country. Also, the development of the financial sector reduces the environmental risk in both models because financial development helps to provide more information about the importance of the environment, especially in developing countries, due to the provision of financial resources and the possibility of accessing more efficient technologies and in model 2, there is a non-linear U-shaped relationship between financial sector development and environmental risk. The FD × FDI interaction term also has no significant effect on environmental risk. The results also show that economic growth and urbanization reduce environmental risk.

This study states that the development of the financial sector in developing countries can increase the quality of the environment. However, the results may be different in a developed financial sector. Most foreign direct investment comes from developed countries with strict environmental regulations; hence, they can transfer superior environmental technologies to the host country. Finally, foreign direct investment paves the way for promoting environmental sustainability in the host country. On the other hand, with the increase in real income, people have more ability to allocate resources to protect the environment and reduce environmental risk. Also, economic growth resulting from improved technology can provide higher returns with lower environmental risk. Urbanization is also beneficial for the environment due to higher living standards, increased public health, positive external effects and economy of scale.