Financial Development and Investment in Emerging Economies: The Moderating Role of Institutional Quality

Abstract

Financial development can facilitate productive investment by improving access to finance, reducing information asymmetries, lowering transaction costs, and directing financial resources toward economically productive activities. However, the effectiveness of financial intermediation may depend on the institutional environment in which financial transactions and investment decisions occur. This study examines the relationship between financial development and investment across 30 emerging economies over the period 2002–2025, with particular emphasis on the moderating role of institutional quality. This study conceptualizes rule of law, government effectiveness, and control of corruption as institutional mechanisms that may condition the contribution of financial development to capital formation. An unbalanced panel dataset is constructed from the World Development Indicators, Global Financial Development Database, and Worldwide Governance Indicators. Investment is measured through gross capital formation as a percentage of gross domestic product, while financial development represents the principal explanatory variable. The analysis incorporates economic growth, inflation, foreign direct investment, external debt, government expenditure, and trade openness as additional determinants. Fixed-effects estimation is initially employed, followed by moderation models, Driscoll–Kraay robust inference, and dynamic Generalized Method of Moments estimation to examine robustness and potential endogeneity. The baseline results indicate a positive association between financial development and investment, while economic growth, foreign direct investment, trade openness, and institutional quality are also positively associated with investment. External debt, inflation, and government expenditure exhibit negative relationships. The moderation analysis produces positive interaction coefficients between financial development and each institutional dimension, indicating that stronger institutional conditions are associated with a stronger estimated relationship between financial development and investment. The dynamic estimates further demonstrate substantial persistence in investment and reveal that the estimated relationship between financial development and investment changes when dynamics and potential endogeneity are incorporated. The findings highlight the importance of combining financial-sector development with institutional strengthening to support productive capital formation in emerging economies.