Could Financial Deepening Be the Solution to the Carbon Emission Problem? Empirical Evidence from CEE Countries.

• Author: Akbulut, Hale

1. Introduction

   Over the past decades, the problem of climate change has attracted the attention of many researchers, politicians, and national and international organizations. It is accepted that greenhouse gas (GHG) emissions, especially carbon, are the main factor underlying this problem. In this context, the European Union (EU) aims to reduce GHG emissions by 55% in 2030 and to be carbon neutral in 2050, within the framework of the European Green Deal. This goal, which is difficult to achieve, also presents difficulties for Central and Eastern European (CEE) countries. In these countries, growth-oriented economic strategies have generally been based on energies produced from solid fuels, and environmental effects have not been given enough attention over the years (Pakulska, 2021).

   However, with EU accession and political transformation, environmental effects have come to the fore. Therefore, it is crucial for these countries to analyze the determinants of carbon emissions and take measures to reduce them. Li et al. (2022) drew attention to the importance of going beyond traditional determinants in this process, and working on deeper environmental factors such as financial depth. Financial depth is a measure of the financial sector in terms of size and liquidity. Thus, it refers to the size of banks, other financial institutions, and financial markets in a country relative to total economic output (WB, 2020). As Shahbaz et al. (2013a) suggest, the exclusion of financial variables in the growth-emissions nexus may lead to the omission of an important variable in the regression. However, the impact of this transformation on carbon emissions is uncertain. Some studies conducted in recent years (Paramati, Mo and Huang, 2021; Li et al., 2022; Wang and Dang, 2022) emphasized the importance of the issue. However, these studies do not focus on CEE countries. However, testing the effects of financial depth on carbon emissions for CEE countries has differences and will make a significant contribution to the literature in at least two respects. Firstly, globalization in CEE countries started especially after the Cold War period, therefore its effects appeared later. Secondly, due to the delay in economic integration, financial depth in CEE countries remained on average lower than in other European countries. While the financial market depth index of the International Monetary Fund (IMF) was 0.35 in Europe as a whole in the 1995-2018 period, in countries such as Bulgaria, Romania, Slovakia, Estonia, Latvia, and Lithuania, it did not even reach the level of 0.10.

   Based on the above discussions, this study aims to examine the determinants of carbon emissions across CEE countries with special attention to the impact of financial depth. For that purpose, in line with the maximum data availability, this study focuses on 11 CEE countries (Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Slovak Republic, Slovenia, Estonia, Latvia, and Lithuania) for the period 1995-2018. This study employs the panel threshold regression methodology developed by Hansen (1999) to test the non-linear impacts of financial depth. This methodology avoids the multicollinearity that may arise if the products and squares of the variables are used. Moreover, it allows us to calculate the specific threshold values that divide the regime into two or more components. Thus, it is possible to make more concrete policy recommendations for each country by comparing the actual financial depth with the calculated threshold values.

   This study has some additional contributions to the literature. Namely, most of the existing empirical literature focused on the effects of financial development and approximated it by two indicators: the ratio of private credit to GDP, and stock market capitalization to GDP. Still, Svirydzenka (2016) draws attention to the multidimensional nature of financial development. With an increase in globalization over time, banks have begun to share their important role in the financial system with actors such as investment banks, insurance companies, mutual funds, pension funds, and so on. According to Abbasi and Riaz (2016), as economies develop, the share of financial sectors in the total economy increases, and the stock market becomes more important than the banking sector. The economic agents now have an opportunity to raise their money through stocks, bonds, and wholesale money markets. Therefore, instead of using proxies that focus on one dimension of financial development, IMF put forth a financial development index that summarizes how developed financial institutions and markets are.

   The index focuses on three factors: depth, access, and efficiency as indicators of financial development. In line with the main objective of the study, we focused on the financial depth index. The index was obtained with a three-step approach. First, the data set was normalized. Second, the normalized variables were aggregated into the sub-indices. And third, sub-indices were aggregated into the final index. We also dealt with the market and institution depth, separately. In measuring the financial institutions' depth--private sector credit to GDP, pension fund assets to GDP, mutual fund assets to GDP and insurance premium, life and non-life to GDP were used. In measuring the financial market depth--stock market capitalization to GDP, stocks traded to GDP, international depth securities of government to GDP, total depth securities of financial corporations to GDP, and total depth securities of nonfinancial corporations to GDP were used. Therefore, instead of focusing on a single variable, these indices contain more information by making use of different variables.

   In sum, the present study will contribute to the existing literature in the following ways. First, this study empirically investigates the impact of the financial depth in the CEE region. Second, it uses the financial depth index in contrast to previous studies that used a single variable to proxy financial development. Third, the relationship between financial depth and carbon emissions is determined through non-linear panel threshold regression. Thus, the multicollinearity problem has been avoided. Fourth, second-generation unit root tests were used considering the cross-sectional dependency. Fifth, thanks to the empirical methodology, it is possible to calculate specific values of thresholds that have regime-switching effects. And sixth, the study differentiates from the previous studies by employing two different dimensions of the financial depth of CEE countries: financial market depth and financial institutions depth.

   The rest of the paper is presented as follows: Section 2 provides a brief review of the related literature; Section 3 presents the methodology; Section 4 presents data; Section 5 reports empirical findings; and Section 6 provides a conclusion and presents relevant policy suggestions.

2. Literature review

   In the literature, the views on the relationship between financial indicators and carbon emissions are controversial. The first view suggests that financial development increases carbon emissions by alleviating credit constraints and increases total output which results in more energy consumption and hence more emissions. As Sadorsky (2010) suggests, financial development can increase demand for energy by making it easier for consumers to buy big-ticket items like automobiles, houses, and air conditioners. Similarly, thanks to financial development, businesses may expand their existing work by hiring more employees, and purchasing more machinery, thereby increasing their carbon emissions.

   On the other hand, the second view suggests that financial development decreases carbon emissions by boosting environmentally-friendly technologies in the production process. Financial development may improve environmental quality through initiated green financing projects such as investment in renewable energy sources, alternative energy fuels, and sustainable projects (Vo and Zaman, 2020). Financial development, on the one hand, provides the necessary capital for green technology investments and reduces financial costs, on the other hand, it may improve allocation efficiency and risk management (Paramati, Mo and Huang, 2021).

   A plethora of empirical work focuses on the nexus of financial indicators--carbon emissions. However, these studies generally focus on financial development as an indicator instead of financial deepening. The studies of Shahbaz et al. (2013a, 2013b) are among the pioneering studies investigating the relationship between financial indicators and carbon emissions using time series data. In Shahbaz et al. (2013b), the nexus was investigated for the case of Malaysia using a bounds testing approach. They used real domestic credit to private sector per capita as a proxy of financial development and included a squared term of financial development in the regression to observe nonlinear effects. While the coefficient of this term was found to be insignificant, they found a negative relationship between financial development and carbon emissions. On the other hand, they confirmed the presence of an inverted U-shaped relationship between financial development and carbon emissions in Indonesia in their other study (Shahbaz et al., 2013a).

   In a later study, Abbasi and Riaz (2016) explored the impact of financial development on carbon emissions in Pakistan. They considered the full sample period of 1971-2011 and a reduced sample sub-period (1988-2011) that corresponded to greater financial development. They employed the share of total credit and the share of private sector credit as the indicators of financial intermediation development. By using the Autoregressive Distributed Lag (ARDL) approach, they observed that financial development mitigates carbon emissions only in the latter sample. On the other hand, financial development increases carbon...