Does Islamic Banking Contribute to Economic Development? Evidence from Malaysia

Abstract

Does Islamic banking contribute to the economic development of a country? In what way Islamic banking contribute to the economic development? Are the main question might be asked to examine the viability of Islamic banking to the economic development. This paper attempts to answer those questions by examining the dynamic interactions between Islamic banking and economic development of Malaysia by employing the Cointegration test and Vector Error Model (VECM) to see whether the Islamic financial system contributes to the economic development and economic development that contribute to the transformation of the operation of the Islamic financial system in the long-run. We use time series data of total Islamic bank financing (IB financing) and real GDP per capita (RGDP), fixed investment (GFCF), and trade activities (TRADE) to represent real economic sectors. We found that in the short-run only fixed investment that granger cause Islamic bank to develop for 1997:1-2005:4. Where as in the long-run, there is evidence of a bidirectional relationship between Islamic bank and fixed investment and there is evidence to support ‘demand following’ hypothesis of GDP and Islamic bank, where increase in GDP causes Islamic banking to develop and not vice versa. Islamic banking is also found to have less contribution to the international trade in the form of export and import of goods and services. 

Keywords: Islamic banking, economic growth, Malaysia, VECM

JEL Classification: C23, G21, L25, E01

 

Introduction

The link between financial development—broadly defined as an increase in the volume of financial services of banks and other financial intermediaries as well as financial transactions on capital markets—and economic growth has long been a major subject in the field of development economics. The financial sector plays a growth promoting role if it is able to direct financial resources towards the sectors that demand those most. When the financial sector is more developed, more financial resources can be allocated into productive use, and more physical capital being formed which can contribute positively to economic growth.

The Islamic financial system in Malaysia has evolved as a viable and competitive component on the overall financial system as a driver of economic growth and development. Malaysia has set up comprehensive Islamic financial infrastructures such as Islamic banking (1983), Islamic insurance (1984), Islamic capital market (1993), Islamic inter-bank money market (1994), Kuala Lumpur Stock Exchange (KLSE) Shariah Index (1999) and in March 2001, Central Bank of Malaysia (BNM) launched the financial sector master plan which incorporated the 10-years master plan for Islamic banking and takaful that is aimed at creating an efficient, progressive and comprehensive Islamic financial system and at the same time, to promote Malaysia as regional financial centre for Islamic banking and finance. In the Financial Sector Master Plan, Central Bank of Malaysia has envisioned Islamic banking to constitute 20% of the banking market share in 2010 (BNM Annual Report, 2003). 

In term of economic growth, Malaysia has a remarkable record of consistently high growth in the past three decades. The growth of GDP in real terms accelerated to 5.3 percent in 2005. As a country slightly shifted toward industrial country, industrial sectors and services contributed 80 percents to total of GDP of Malaysia. With total population 26.7 million, Malaysia maintains its Per capita GDP above US$ 3,000 since 1995.

A well developed Islamic financial system and a tremendous economic growth at the same time pull our attention to examine whether or not the Islamic banking system that currently applied in Malaysia really contribute in the long-run to economic growth of Malaysia. To do this, we will look at the dynamic interactions between finance and growth by applying models where the financial system influences economic growth and economic growth transforms the operation of the financial system.

1. Islamic Banking in Malaysia

Malaysia established the first Islamic bank in July 1983 with the incorporation of Bank Islam Malaysia Berhad. After a decade, in March 1993, Malaysia introduced an Interest free banking scheme (SPTF). Under this scheme 17 conventional financial institutions (9 commercial banks, 6 finance companies, and 2 merchant banks) participated and offered Islamic-financing techniques by opening separate Islamic counters in their branches known as ‘Islamic windows’. In the second decade, as at the end-December 2003, the Islamic banking system had 33 players, comprising 2 Islamic banks, and 31 conventional banking institutions participating in the Islamic Banking Scheme that consisted of 9 commercial banks, 4 foreign banks, 7 finance companies, 4 merchant banks and 7 discount houses (BNM Annual Report, 2003).

The rapid evolution of the domestic Islamic financial system has set the stage for its global integration. Now developmental efforts in Islamic finance have also been intensified to position Malaysia as an international Islamic financial hub that will have a greater role in facilitating international economic and financial flows. These efforts have been directed towards institutional development, enhancing the domestic financial infrastructure, strengthening the Shari’ah and legal infrastructure, and promoting greater international integration. In line with measures to promote foreign participation and the transfer of knowledge and expertise, foreign equity participation of up to 49% has been allowed in Islamic banking subsidiaries and new takaful companies in Malaysia. In 2005, Malaysia issues licenses for foreign Islamic bank to operate in Malaysia and transforms the ‘Islamic windows’ in conventional banks to ‘Islamic subsidiaries’ (BNM Annual Report, 2005).

In term of financial performance, the Islamic banking industry as a whole  showed commendable results in 2005, with profitability and assets surpassing for the first time the RM 1 billion and RM 100 billion thresholds respectively. The total assets of the Islamic banking sector in 2005 increased significantly by RM16.8 billion or 17.7% to RM111.8 billion with more than half of the increase attributable to a 16.5% (RM9.5 billion) growth in total financing. As at the end-2005, total outstanding financing amounted to RM67.4 billion (2004: RM57.8 billion) or 60.2% of the total Islamic banking assets (BNM Annual Report, 2005: 166)

The good performance and rapid growth of Islamic financial industries in Malaysia, nevertheless, proved the feasibility of the system. The system has become an integral part of the country’s financial system in both total assets and the number of players in the industry. However, some evaluations are important not only to verify the efficiency and effectiveness of the financial system and products but most importantly to examine its contribution to the economic development in general. As it has been declared by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, “our quest to develop a dynamic Islamic financial system is to achieve the ultimate objective for Islamic finance that contributes significantly toward the overall development of our economies. This is achieved through the intermediation process to facilitate trade, business and investment. This will facilitate the integration of the Islamic financial system as a viable component of the global financial system”.

2. Finance and Growth Nexus: A Literature Review

The issue on finance and economic growth is actually dating far back into the 19th century at least where Joseph A. Shumpeter (1912) argued the importance of the banking system on the level and growth rate of national income in fostering economic development via the identification and funding of productive investment.

More recently, many studies have attempted to deepen this analysis empirically by exploring specific indicators to explain the causal relationship between finance and growth. Three apriori possibilities come to fore, (1) financial development is a determinant of economic growth—“supply-leading”; (2) financial development follows economic growth—“demand-following”; and (3) bidirectional causality between finance and growth.

The empirical test results, however, are mixed and the causality patterns appear to be diverse. Jung (1986), Demetriades and Luintel (1996), Ahmed and Ansari (1998), Rousseau and Wachtel (1998), Xu (2000), Arestis et al. (2001) and Fase and Abma (2003) argue that expansion of the financial system could have a positive repercussion on economic growth. The financial sectors in this case act as ‘supply leading’ to transfer resources from the traditional, low-growth sectors to the modern high-growth sectors and to promote and stimulate an entrepreneurial response in these modern sectors (Patrick, 1966:75).

Robinson (1952: 86), on the other hand, believes that economic growth leads to the development of financial sector, he called "where enterprise leads finance follows". In this regard, Masih and Masih’s study (1996) supports demand following hypothesis where economic growth causes financial sectors to develop. On this view the more rapid the growth of real national income, the greater will be the demand by enterprises for external funds (the saving of others) and therefore financial intermediation, since in most situations firms will be less able to finance expansion from internally generated depreciation allowance and retained profits. The financial system can thus support and sustain the leading sectors in the process of growth. In this case an expansion of the financial system is induced as a consequence of real economic growth or ‘demand following’.

 On the other hand, the studies by Odedokun (1992) and Luintel and Khan (1999) favor bidirectional causality between finance and growth. Both financial and economic developments are causally related where financial development causes economic to grow and economic growth triggers financial sector to develop further.

However, there are also economists such as Lucas (1988) who believe that finance is not important at all. Harris (1997) confirms this theory. He provides evidence that stock market can not explain growth in per capita output. Furthermore, recent studies by Galindo and Micco (2004) provide cross-country evidence that state owned banks do not promote the growth rates of manufacturing industries that rely on external sources of funding for their operation and/or that due to reduced access to collateral face tighter financial constraints. 

On the Islamic financial system, the empirical studies so far have been done to examine the efficiency, superiority and stability of Islamic bank compared to conventional bank to achieve some intermediate monetary target for the ultimate target which is concentrated towards the achievement of sustaining real economic growth, reducing inflation and lowering unemployment. The results, however, are mixed. Darrat (1988) found that interest-free banking system is more superior to achieve the monetary target, meanwhile Yousefi et al (1997) and Yusuf and Wilson (2005) found no evidence of the superiority and stability of interest-free banking system compared to interest based banking system. Specific empirical studies on relationship Islamic finance and economic growth however is very rare.

(Writen by: Hafas Furqani & Ratna Mulyany on TIFBR Journal)