Does institutional quality moderate the relationship between foreign capital and financial markets? Insights from emerging and advanced economies

Abstract

Foreign capital plays a pivotal role in shaping financial markets; however, its effects differ across investment types and institutional contexts. This study examines how greenfield investment, mergers and acquisitions (M&A) and foreign portfolio investment (FPI) influence financial market development (FMD), with institutional quality (IQ) as a moderating factor, in emerging and advanced economies from 2003 to 2021. Using panel-corrected standard errors (PCSEs) and two-step system generalized method of moments (GMM) estimations, we find that in emerging economies, greenfield investment constrains FMD, while M&A fosters it. FPI has an insignificant negative impact, whereas IQ has an insignificant positive effect. In contrast, in advanced economies, greenfield investment, M&A and strong institutions collectively support FMD, whereas FPI remains neutral. Moderation analysis reveals that robust IQ not only positively moderates the negative impact of greenfield foreign direct investment (FDI) on FMD in emerging economies but also amplifies the benefits of foreign capital in advanced economies. The findings highlight that emerging economies should channel efforts towards facilitating M&A, while advanced economies should prioritize attracting greenfield FDI. Crucially, in both settings, strengthening IQ emerges as the decisive lever for transforming diverse foreign capital inflows into robust FMD.