Are the Shadow Economy and Country Risk Barriers to Financial Development?: Evidence From Cross Countries Analysis

This study examines the impact of the shadow economy (SEC) on financial markets and institutions development in N‐11 countries, using data from 1995 to 2018. Moreover, the study also examines the moderating role of country risk consisting of political (PR), financial (FR) and economic risk (ER) in shaping financial institutions and market development by managing the SEC. The study used panel unit root and cointegration tests for identifying stationarity and cointegration in the series, followed by the panel autoregressive distributive lag (ARDL) technique to estimate the long‐run relationship. The study's empirical analysis reveals that SEC and ER along with FR negatively affect the development of financial markets and institutions. The study also indicated that country risk (PR, ER and FR) moderates the adverse impact of the SEC on financial institutions and market development. Employing the VEC/Block exogeneity causality test, a one‐way causal nexus runs from PR to ER, and SEC to economic growth is identified. Furthermore, the study suggests that N‐11 countries should reduce shadow economic activities and country risk to promote the development of financial markets and institutions.