Academic journal article Journal of Economic Cooperation & Development

The Islamic Banking and Economic Growth Nexus: A Panel VAR Analysis for Organization of Islamic Cooperation (OIC) Countries

Academic journal article Journal of Economic Cooperation & Development

The Islamic Banking and Economic Growth Nexus: A Panel VAR Analysis for Organization of Islamic Cooperation (OIC) Countries

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1. Introduction

The relationship between financial development and economic growth has attracted a great deal of attention targeted at improving the banking industry and other financial intermediaries. One of the most important factors of economic growth is the financial market. When financial markets develop, individuals tend to save more, leading to increased capital accumulation. The increase of capital accumulation in turn stimulates investments. As a result of increased investment, more capital is allocated to the process of production, thereby contributing positively to economic growth. There are many different views related to the financial market and economic growth nexus. Levine (1997) indicated that financial intermediaries play an important role. Financial intermediaries are a part of financial markets that not only provide risk diversification services but also help to allocate resources for economic growth.

The role of Islamic finance has increased in importance over time in the financial markets. Although the modern history of Islamic finance began nearly forty years ago, massive improvements achieved after the 1980s, especially with regard to Islamic finance, have led to rapid growth in recent decades. While Islamic assets were approximately USD 150 million in the 1990s (Grewal, 2011), the market size of these assets is estimated to reach USD 2 trillion at the end of 2014 (Cummings, The City UK, 2013). With regard to the development of Islamic finance, Islamic banking, that is, interest-free banking, has been rapidly increasing in importance. The rules of Islamic banking are based on principles of Sharia. Money is used as a medium of exchange. Furthermore, these banks are prohibited from certain transactions such as any business concerning alcohol, gambling, excessive speculation. Apart from these, profit and loss sharing principles are the crux of Islamic finance. According to profit and loss sharing (PLS), the relationship between lender, borrower, and intermediary depend on financial trust and partnership (Yudistira, 2004). There are three basic components of Islamic financial institutions, especially Islamic banking, that can compete against other financial constructions. Meanwhile, these components help to promote socially and ethically responsible business practices. Business practices are crafted under Sharia supervision, screening, and community based investment (Zäher and Hassan, 2001).

Although the Islamic banking and economic growth nexus has garnered some attention in academic literature, to date there are limited studies about this subject. Furqani and Mulyany (2009) shows there is a relationship between Islamic finance and economic growth. While they found no causal relationship between Islamic banking and economic growth in the short term, they did find a uni-directional relationship between Islamic banking and investments. When investments increased by Islamic banking, real sectors developed in Malaysia. However, in the long term the increase in Islamic banking finance encouraged an entrepreneurial response in the productive sectors and increased investments, while at the same time increased investment supported the development of Islamic banking. On the other hand, financial development follows economic growth. Economic growth causes Islamic banking institutions to change and develop. When an economy grows, it creates a demand for financial intermediation.

We aim to determine that the economic growth and Islamic banking nexus is significant and to describe the effects of Islamic banking on economic growth in the long run by using Panel VAR analysis for members of the Organization of Islamic Cooperation (OIC). First, we used panel fixed effect regressions to analyze the relationship between economic growth and Islamic banking sector variables, employing other determinants of economic growth. Second, to understand the long-run relationship between both of them, we apply a panel data vector-autoregressive model, which is followed by impulse response function and forecast error variance decomposition. …

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