Digital Financial Inclusion and Institutional Quality as Drivers of Green Economic Growth: Pathways to Sustainable Development

The revolution of digital financial inclusion (DFI), powered by various forms of fintech, is crucial for a country's economic development and competitiveness. It provides economic entities—the engines of growth and job creation—with easy, fast, and cost-effective access to financial services, contributing to improved community quality of life. Simultaneously, the green economy has become a central policy focus in the pursuit of sustainable development.

The impact of DFI on a country's economy is multifaceted, influencing environmental sustainability, economic growth, and social well-being. By expanding financial access, encouraging sustainable investments, and enhancing resource efficiency, it contributes to a greener economy. The continuous advancement of financial technologies further strengthens their role in promoting environmental sustainability and accelerating the shift toward a low-carbon, resource-efficient economy.

The COVID-19 pandemic has transformed digital financial services, making DFI crucial to ensure universal access to these services and foster sustainable economic growth. Efforts to advance DFI should align with and contribute to achieving the 2030 Sustainable Development Goals (SDGs) [1].

DFI has been widely studied in relation to economic growth, with many analyses concluding that it enhances economic development and can contribute to GDP growth [2-6].

The concept of inclusive green growth focuses on achieving SDGs by fostering equality in economic growth and promoting green economic benefits. It seeks to address social and environmental challenges arising from traditional, unsustainable economic practices. Within the framework of inclusive green growth, the emphasis is on advancing an "inclusive" and "green" strategy for sustainable economic development. This approach has become a crucial initiative for developing countries to meet their dual-carbon targets while maintaining social harmony and stability.

Researchers argue that financial inclusion through green finance is closely linked to climate action, as it enables individuals and businesses to invest in environmentally friendly technologies and practices. It enables businesses to invest in green industries such as renewable energy projects, solar panels, wind turbines, and energy-efficient equipment. This shift in investment behavior among entrepreneurs and businesses fosters climate resilience by expanding access to renewable energy for marginalized communities [7], which are often more vulnerable to the impacts of climate change. Consequently, financial inclusion is recognized as a critical driver of green economic growth (GEG) and the achievement of SDG 13 on climate action.

Several countries in South-Eastern Europe (SEE), particularly those in the Western Balkans, still remain transition and developing economies with relatively low economic growth. Although these economies have achieved moderate industrial development, they also suffer from high levels of environmental pollution with high carbon dioxide emissions. Environmental pollution mainly results from the lack of investment in gasification. Households, businesses and public institutions still use environmentally unfriendly energy sources. Low-income levels, politicization of institutions, corruption, lack of rule of law, low investment in renewable energy, low culture for environmental protection do not support sustainable economic development.

The study aims to assess the impact of DFI and institutional quality on GEG by analyzing data from countries in the SEE region from 2011 to 2021. Specifically, we focused on various digital financial instruments and examined their effects on green economic efficiency. Based on the purpose of the paper, we have derived the following hypotheses:

H1: DFI can contribute to GEG by improving access to sustainable finance and promoting the efficient allocation of resources in environmentally sensitive sectors.

H2: Institutional quality supports and enables sustainable economic growth.

H3: The interplay between DFI and institutional quality has a synergistic effect on GEG.

This study measures the nexus between DFI and IQI as a mediating variable on GEG for selected SEE countries (Albania, Austria, Bosna and Hercegovina, Bulgaria, Croatia, Czechia, Greece, Montenegro, North Macedonia, Hungary, Romania, Italy, Serbia, Slovenia, Slovak Republic and Turkiye for years 2011, 2014, 2017 and 2021. As Global Findex survey data is only available for these years. From this sample, we have excluded some SEE countries due to lack of data.

The purpose of this paper is to evaluate the role and impact of DFI and institutional quality on GEG. Building on the work of Khera et al. [29] and Miftari et al. [30], we develop a DFI index and Traditional Financial Index (TFI) by applying the Principal Component Analysis (PCA) method, enabling the integration of multiple indicators into a unified composite measure. This statistical technique is used to reduce the dimensionality of the data, identifying patterns and simplifying the dataset by transforming correlated variables into a set of linearly uncorrelated components (principal components). A one-stage PCA is used to construct this index.

IQI constructed through PCA method from four World Development Indicators (political stability, rule of law, regulatory quality, and government effectiveness), was introduced as a mediating variable alongside the primary independent variables.

IQI serves as a proxy for governance effectiveness, which can strengthen the role of DFI in fostering GEG by improving policy implementation, regulatory oversight, and resource allocation efficiency.

Following growth theory, we incorporate control variables like final consumption expenditure (FCE). FCEs have a significant impact on economic activities [31, 32]. Additionally, it can be linked to GEG in various forms and ways.

We also include Foreign Direct Investment (FDI) and Trade (TR) as instrumental variables to account for additional factors that may influence both economic growth and GEG.

Table 1. Variables descriptions

Data was gathered from various sources, with detailed information on variable definitions, measurements, and sources available in Table 1. The main aim is to assess the impact of two components of financial inclusion (FI) and IQI on GEG. Additionally, the research examines the relationships among final consumption expendituare (FCE), trade openness (T), FDI, and GEG. TFI and digital financial index (DFI) were developed using PCA, with results presented in Appendix Table A1-A3.

Following previous studies [33, 34], we calculated GEG using the formula GEG=GDP+EE−NRD−CO₂.

GDP indicates the monetary value of goods and services, (annual%), EE is the monetary value of education spending (% of GDP), NFD is natural resources depletion (% of GNI), and CO₂ is the monetary value of carbon dioxide emissions. GEG is calculated by adjusting traditional GDP to account for both positive contributions and undesirable outcomes. On the positive side, we incorporate education expenditure as a key driver of sustainable development, recognizing its role in fostering innovation, green skills, and long-term productivity. On the negative side, we deduct net resource depletion and carbon emissions to reflect environmental degradation costs. This adjusted metric provides a more comprehensive view of economic progress by balancing growth with ecological and social sustainability.

The literature reveals methodological diversity in assessing financial inclusion's effect on GEG, with different studies applying fixed effects specifications, pooled OLS regressions, dynamic GMM frameworks, etc.

To identify the most appropriate regression model for our dataset, whether it be pooled OLS, fixed effects, or random effects, the results of Hausman test revealed that robust fixed effects regression model is preferred due to the correlation between the individual effects and the regressors. The results of modified Wald test for groupwise heteroskedasticity in fixed effect regression model show existence of heteroscedasticity, and finally we use the robust fixed effect model. Furthermore, the fixed-effects approach enables more robust estimation of DFI's impact on green growth by controlling for unobserved countries specific heterogeneity. The empirical model is specified as follows:

$Y_{i t}=\alpha_{i t}+\beta X_{i t}+\delta_t+\mu_{i t}+\varepsilon_{i t}$         (1)

The model specification is as follows:

$\begin{gathered}G E G_{i t}=\beta_0+\beta_1 T F I_{i t}+\beta_2 D F I_{i t}+\beta_3 I Q I_{i t} \\ +\beta_4 F C E_{i t}+\beta_5 F D I_{i t}+\beta_6 T R_{i t}+\delta_t+\mu_{i t}+\varepsilon_{i t}\end{gathered}$         (2)

$\begin{array}{rl}G D P_{i t}=\beta_0+\beta_1 T \, F I_{i t}+\beta_2 D F I_{i t}+\beta_3 I Q I_{i t} \\  +\beta_4 F C E_{i t}+\beta_5 F D I_{i t}+\beta_6 T R_{i t} +\delta_t+\mu_{i t}+\varepsilon_{i t}\end{array}$        (3)

To test the moderating role of institutional quality on the impact of DFI on GEG we developed this regression equation:

$\begin{array}{rl}G D G_{i t}=\beta_0+\beta_1 T \, F I_{i t}+\beta_2 D F I_{i t}+\beta_3 I Q I_{i t} \\  +\beta_4\left(D F I_{i t} \times I Q I_{i t}\right)+\beta_5 F C E_{i t} \\  +\beta_6 F D I_{i t}+\beta_7 T R_{i t}+\delta_t+\mu_{i t}+\varepsilon_{i t}\end{array}$              (4)

where,

GEG_it = Green economic growth (dependent variable)

GDP_it = Gross Domestic Product

TFI_it = Traditional financial inclusion index (explanatory variable)

DFI_it = Digital financial inclusion index (explanatory variable)

IQI_it = Institutional quality index (mediating variable)

(DFI_it×IQI_it) = Interaction term

FCE_it = Final consumption expenditure (control variable)

FDI_it = Foreign Direct Investment (control variable)

TR_it = Trade (control variable)

i = Cross-sectional unit (countries)

T = Time period (year)

$\mu_i$=Country-specific fixed effects (time-invariant heterogeneity)

$\delta_t$= Time-specific effects (coefficient for year fixed effects)

$\varepsilon_i$= Error term

This research aims to explore the influence of financial inclusion and institutional quality on GEG, alongside control variables such as FCE, FDI, and trade. The study employed regression analysis using a fixed effects model. The findings indicate that financial inclusion, categorized into traditional and DFI, has a positive but statistically insignificant effect on GEG. Our results align with the work of [11, 21, 35]. These findings reveal that DFI is positively associated with GEG as well. But in contrast with those of Abass [34], whose research indicates a significant negative impact of financial inclusion on GEG. The weak link between DFI and GEG in SEE countries stems from multiple structural and institutional factors. These include: a disproportionate focus of DFI on payment services rather than green lending products; the continued market dominance of traditional banks that favor conventional over sustainable financing; limited opportunities for green investment across the region, etc. Furthermore, the results of this study also indicate an insignificant positive relationship between institutional quality and GEG. These findings are consistent with those of Tiwari and Bharadwaj [36], who found that countries with more stable institutions tend to experience higher economic growth but contradict the conclusions of Meniago [26] and Degbedji [28]. The limited impact of institutional quality on GEG can be attributed to significant heterogeneity in governance frameworks across the region, particularly between EU and non-EU member states in SEE. Non-EU countries exhibit notably higher levels of corruption, weaker rule of law, and lower institutional investments in innovation and development compared to their EU, aligned counterparts factors that critically constrain their capacity to foster sustainable growth.

At first glance, a negative coefficient for FCE appears to contradict the principles of economic growth, including GEG. However, this observation can be understood in the context of declining economic growth, particularly during the period from 2011 to 2020, when both households and businesses reduced their consumption, leading to decreased economic activity. If final consumption does not prioritize sustainable goods and services, it can have detrimental effects on the environment and hinder progress toward green growth objectives [37].

Additionally, a negative FCE index may indicate a shift in consumer behavior towards increased savings. Although this shift may hinder short-term economic growth, it could encourage long-term sustainability by fostering green investments.

In summary, while a negative FCE index might seem harmful to immediate economic growth, it could also signal a transition towards more sustainable consumption patterns and investments in green technologies. This shift represents a long-term commitment to an economy that prioritizes environmental sustainability over short-term growth.

While control variables such as FDI and trade revealed a significant positive relationship with GEG and economic growth.

This work is supported by AAB College.