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Do financial development and political institutions act as substitutes or complements?

ABSTRACT This paper examines the interactive impact of financial development and political institutions on a specific development outcome: gross domestic investment. We explore whether financial development and political institutions act as substitutes or complements in the context of domestic investment. Using data from the period 1975–2017 for 131 countries to construct annual and five-year interval panels, we employ Fixed Effect (FE) and Dynamic Panel estimators (System GMM) to test our hypothesis. We find a significant interactive impact of political institutions and financial development on domestic investment. More specifically, we find a substitution effect among these factors. In the presence of inefficient institutions, financial development mitigates the negative impact of political institutions on domestic investment, and vice-versa.