Does financial development cause sustainable development? A PVAR approach

Sustainable development (SD) strives to protect the environment and promote an inclusive prosperity. However, achieving this partly rests on the effectiveness of financial development (FD) among other factors. On the one hand, FD fosters eco-friendly investment, financial inclusion and economic growth and thus leads to SD. On the other hand, FD may result in financial instability, social inequality and environmental degradation by fueling unsustainable economic activity and deter the achievement of SD. Given the quandary, this study attempts to investigate the causal effect of FD on SD for 143 countries during period 1990-2020, where SD is represented by adjusted net savings (ANS), and a new index, using the principal component analysis, is constructed to measure FD. Results of the panel vector autoregression method reveal that FD has a causal relationship with SD, which is unidirectional in general; however, the causality between financial market index and ANS is bidirectional. In general, the results also suggest that FD is essential for SD; nevertheless, policymakers must monitor the possible downside of FD that may undermine its contribution to sustainability. The study bears important policy implications, and as far as the knowledge goes, this is the first paper that explains the comprehensive FD-SD causality.