Do institutional quality and economic freedom matter for the finance-growth nexus? Empirical evidence from Nepal

Abstract

Many studies explored the finance-growth nexus by using the proxy of several variables via multifaceted channels; however, a few of them addressed the role of institutional quality (IQ) and economic freedom (EF) on the finance-growth nexus in Nepal. This study thus explores the finance-growth nexus with the moderating role of IQ and EF. Using time-series data from 1996 to 2023, this study applied the autoregressive distributed lag (ARDL) model to analyze the finance-growth nexus with and without the moderating role of IQ and EF. In the long run, financial development (FD) positively influenced economic growth; however, the interaction of FD with IQ exhibited a positive but weakly significant effect (β=0.025, p<0.10). Additionally, the interaction between FD and EF evidenced a positive and significant effect on growth (β = 0.184, p < 0.01) in Nepal. Likewise, IQ and government expenditure have a negative effect on growth, and EF and trade (only after mediation) have a positive effect on growth, where IQ and EF have a positive effect on the finance-growth nexus in the long run. On the flip side, in the short run, the independent effect of financial development was negative, but the joint effect of financial development and institutional quality, as well as financial development and economic freedom, had a significantly positive impact on economic growth in Nepal. The empirical evidence suggests that financial development alone is not enough to promote economic growth in Nepal; instead, the quality of institutions and economic freedom become the main moderators of the finance-growth nexus. Therefore, policymakers must focus on improving their governance systems and embracing market-based reforms to achieve maximum growth potential through financial development.