Islamic Banking Presence and Economic Growth in Southeast Asia

International Journal of Islamic and Middle Eastern Finance and
Management
Islamic banking presence and economic growth in Southeast Asia
Hind Lebdaoui, Joerg Wild,
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Islamic banking presence and Islamic

banking
economic growth in presence
Southeast Asia
551
Hind Lebdaoui
International Education School, Received 22 March 2015
Shanghai University of Finance and Economics, Shanghai, China, and Revised 11 October 2015
11 January 2016
Accepted 26 February 2016
Joerg Wild
School of Finance, Shanghai University of Finance and Economics,

Shanghai, China
Abstract
Purpose The purpose of this study is to empirically assess the relationship between Islamic banking
presence in Southeast Asian countries and the economic growth.
Design/methodology/approach The presence of Islamic banks is measured by the ratio of
Islamic to conventional banking assets as well as the ratio of deposits of Islamic to conventional
banking. This study starts by checking the presence of cointegration using Pedronis and
Westerlunds specifications; short- and long-run dynamics are further analyzed with the panel
autoregressive distributed lag model (ARDL)-based estimators: pooled mean group (PMG), mean
group (MG) and dynamic fixed effect (DFE). Furthermore, a two-stage regression [two-stage least
squares (2SLS)] was constructed to measure the sensitivity of economic growth to the Islamic
banking presence. Quarterly data from Southeast Asian countries cover the period between 2000Q1
and 2012Q4.
Findings A long-run relationship is evident between economic growth and the Islamic banking
presence in the selected region, but not in the short run. Furthermore, the Muslim population share in a
given country plays a positive and statistically significant role in fueling the contribution of Islamic
banking share in the financial sector on the economic growth.
Social implications The results of this study show that Sharia-compliant banks succeeded in
mobilizing additional resources for the financial sector, which may increase the stability of the banking
system and the efficiency of the whole banking sector. The authors believe that the inclusion of Islamic
banking products in the financial systems will, along with the diversification effect, stimulate financial
deepening and, therefore, improve the financial stability in the countries under investigation in
particular, and all countries with significant Muslim population in general.
Originality/value This study empirically assesses the contribution of Islamic banking presence
on the economic growth with a focus on Southeast Asia, as this region encompasses the most
developed and experienced institutions in the field of Islamic finance. Error correction-based
models such as PMG, MG and DFE lend itself to the analysis of the panel data. This study also uses
the instrument-based 2SLS to cope with the endogeneity problem between the real and financial
International Journal of Islamic
sectors. and Middle Eastern Finance and
Management
Keywords Islamic banking, Panel cointegration, Economic growth, Error correction model, Vol. 9 No. 4, 2016
pp. 551-569
Financial deepening, Two-stage OLS Emerald Group Publishing Limited
1753-8394
Paper type Research paper DOI 10.1108/IMEFM-03-2015-0037
IMEFM 1. Introduction
9,4 The global financial crisis has shed doubt on the functioning of financial markets in the
USA and worldwide. The creation of high amounts of previously deemed riskless debts
for the financing of an unsustainable housing market combined with global integration
of financial market led to an unprecedented spread of foul debt to the whole world. In the
context of the ensuing paradigm shift, politicians as well as economists started to
552 explore alternative financial concepts such as Sharia-compliant banking. In light of the
global financial crisis, Sharia-compliant financial products display several interesting
advantages. First, the alternated risk profile of these products can serve as a method of
portfolio diversification. Second, Sharia-compliant products allow some parts of the
unbanked Muslim community to participate in the financial markets that otherwise
would shun conventional banking institutions for religious reasons. Both reasons would
suggest that the introduction of Islamic banking in countries with Muslim population
can contribute to financial deepening and increase the stability of the banking sector, as
argued by Beck et al. (2013), with financial deepening itself being an important
contributor in the economic growth (Schumpeter, 1911).
In this paper, we attempt to empirically assess the relationship between the presence
of Islamic banking and economic growth for Southeast Asian countries with a
significant share of Muslim population in particular. This case can be seen as a proxy for
other countries in the same situation where, because of regulatory restriction, Islamic
banking is not permissible. The presence of Islamic banking is measured by both, the
total assets and deposit of Sharia-based banks to conventional banking, which, in turn,
are well-established proxies for financial deepening. The relationship between financial
structure/deepening and economic growth has been established in numerous studies
throughout the past century. However, few studies deal with Islamic banking presence
as a proxy for financial deepening and economic growth and none exists specifically for
our case of Southeast Asian countries. We try to mitigate this by focusing our research
for these economically important countries not only because of their paramount global
importance of Islamic banking but also because of their significant percentage of
Muslims to their respective total populations.
The main contributions of this research paper are as follows: first, for some of the
countries in our sample, no data were available through the prevalent databases. We
conducted extensive research from central banks and government authorities, a process
that consumed a significant proportion of the total time used for the completion of this
study. Second, previous studies exclusively focused on Gulf Cooperation Council (GCC)
or Malaysia and Indonesia only presumably because of a lack of data. Moreover,
although previous studies have dealt with relationship between conventional banking
and growth and were more concerned with variables measuring financial deepening or
development, this study focuses on the importance of the presence of Islamic banking
system and its impact on growth. Third, previous studies used bank-level data via
Bankscope BvD or Zawya databases, thereby omitting some banks which were included
in our data collected from central banks and national authorities. Fourth, we included
the ratio of Islamic banking assets to conventional banking assets, which allows us to
directly assess the impact of the presence of Islamic banking on the economies under
scrutiny. Fifth, from a conceptual point of view, our methodology incorporates a
causality analysis, a two-stage model and fixed and random effects to take into account
possible country effects.
Empirically, we first conduct a panel unit root test to ensure stationarity along the Islamic
lines of Fisher panel unit root (Choi, 2001) specifications. Second, we engage in banking
cointegration analysis using Pedronis (1999) and Westerlunds (2007) specifications to
asses the long-run relationship between the output growth and the Islamic banking
presence
presence as well as error-correction-based autoregressive distributed lag with mean
group (MG), pooled mean group (PMG) and dynamic fixed-effect model for the short-run
relationship, and we conclude with a two-stage least square (2SLS) and fixed and 553
random effect models to deal with endogeneity for the long-run nexus. As for the
structure of this paper, the next section discusses a selective review of the related
literature. Section 3 introduces data sources and the methodology in detail. Section 4
presents the results, and Section 5 shows our conclusions.
2. Literature review
The financial sector and the economic growth nexus has received a lot of academic
interest. Linking these two sectors is justified by the fact that financial institutions have
a clear influence on the two main components of the output of a country: savings and
investment, and therefore may easily influence its growth. Levine (2005) broke down the
impact process into five main stages: first, pool and optimize savings and, second,
gather information about possible investments and prepare an optimal capital
allocation. Once funds are allocated, the financial institution is called to carry on
measures to look after the corporate governance and ensure risk management and
diversification to, in the end, facilitate goods and services exchange. For this process to
be completed, many environmental conditions are required: law enforcement, regulation
and market policies to name few. Jorgenson et al. (2005) added that the productivity is an
essential requirement for saving accumulation to trigger the economic growth. Many
arguments have been put forth as to whether the developments in the banking system
actually boost economic growth and whether parts of the financial body (banks or stock
markets) may contribute to the growth process. The seminal work of Schumpeter (1911)
was one of the first to tackle this matter and explained how banks actively stimulate
economic growth by identifying profitable investments. Greenwood and Smith (1997)
summarized the nexus of finance and economic growth in the feedback ligature between
both sectors. As the economys growth is high, the financial sectors chance to thrive is
higher, leading to a faster growth; the presence of a direct link, however, cannot be
automatically concluded. Early stages of financial development are more demanding in
terms of scales cost; therefore, the financial development needs to reach a certain level or
threshold to start pay off and show progress on the economic development. Schumpeter
(1911) defined this level as a critical mass. Lucas (1988) stated that this relationship is
over-stressed, and the presence of inflation might cause the financial development to
impede economic growth. He argued that finance is unable to spur the economic growth
or vice-versa.
Similar to conventional finance, the contribution of Islamic finance to growth is still
unclear; however, a majority of studies in this field concluded that a positive relationship
between Islamic banking and economic development exists because of the improved
stability, efficiency and profitability ensured by profit and loss sharing (PLS)-based
finance. Yet, this literature lacks empirical assessment. On the other hand, Obaidullah
(2000) expects the Sharia-based banks to influence the economic development through
the government spending; he posits that government investments in infrastructure
IMEFM mostly rely on an optimal sharing of risks and rewards, and Islamic intermediaries seem
9,4 to be best suited to play this role with its PLS tenet. Bagehot (1873) argued that the key
success of a bank starts by considering the creditworthiness of firms and aggregating
the risk to boost economic growth. By sharing the risk between lender and borrower, the
Islamic banks seem to be more efficient, because moral hazard will have no place in such
a banking style, more optimal distribution of liquidity will take place and funds will be
554 channeled toward more profitable, innovative and prudent projects (Siddiqi, 1999).
Khan and Mirakhor (1990) argued that Islamic banking should have a special treatment,
akin to an equity-based system, because of its PLS tenet: depositors are considered as
shareholders (alike mutual funds), and no guarantee of return is made based on the face
value of a loan or deposits. Symmetrically, a partnership emerges between borrowers
and banks, and accordingly, returns obtained are shared based on an agreed-upon
sharing schema. This feature induces the flexibility and ability to adjust to shocks and,
therefore, to cope with banking crises. Some studies attempted to showcase the nexus at
the country level, such as Abduh and Omar (2012) who tested the relationship between
Islamic banking and the economic growth using quarterly time series of economic
growth, total deposits and total financing in Bangladesh from 2004 to 2011. Using
cointegration and Granger-causality approaches, they concluded that a positive
association between the two sectors in both long run and short run exists. Hasan and
Dridi (2011) examined the performance of both interest-free and traditional banks
during the 2007-2008 financial crisis. Their comparative study covered the profitability,
the credit and assets growth and the external ratings of respective banks in countries
where banks had significant market shares, and their finding suggested that the shock
impacted each of the aspects differently from bank to bank. Although Islamic banking
system was faced with a larger decline in profitability because of the luck in risk
management practices, it accumulated a higher growth in assets and credit rating. This
study corroborated the fact that Islamic banks foster the economic and financial
stability (Abduh et al., 2011; Kassim and Majid, 2010). Based on monthly data, Abduh
et al. (2011) analyzed the sensitivity of deposits in both banking systems to changes in
interest rate, inflation, profit level and financial shocks. Although inflation negatively
influences the level of deposits, the findings show no evidence of the sensitivity to
interest and profits fluctuations. Surprisingly, the deposits of Sharia-based banks react
positively in case of financial crisis. Whereas, the findings of Kassim and Majid (2010)
did not support Abduh et al.s (2011) hypothesis of Islamic banks being resilient to
financial crisis, but unveiled the vulnerability of both systems to financial shocks. In the
case of Malaysia, Furqani and Mulyang (2009) used the cointegration test and the vector
error correction model to investigate the dynamic interaction between Islamic banking
and economic growth through fixed investment in Malaysia for the period spanning
from 1997 to 2005. The demand following hypothesis is confirmed, and results showed
that economic development Granger-causes Islamic banking development and not the
other way around. Abduh and Omar (2012) used data from 2003 to 2010 and applied the
autoregressive distributed lag model (ARDL) framework to the bound testing approach
of cointegration and error correction models (ECMs). Their results reveal a significant
bidirectional relationship in both short and long run between Islamic banking
resurgence and economic growth.
Using a panel cointegration framework, with variance decomposition and impulse
response functions, Mohd. Yusof and Bahlous (2013) constructed a panel of top Islamic
banks from five GCC countries and two East Asian countries. For the period between Islamic
2000 and 2009, their findings show that Islamic banking does contribute to economic banking
growth in both long run and short run. Based on a similar sample, Farahani and Dastan
(2013a) built a Granger-causality model based on data from Malaysia, Indonesia,
presence
Bahrain, UAE, Saudi Arabia, Egypt, Kuwait, Qatar and Yemen. Results show that both
in the long and short run, a positive and significant bidirectional Granger-causality
exists between Islamic banking and the economic growth and capital accumulation in 555
the selected countries. Grassa and Gazdar (2014) conducted a comparative study
between Islamic and conventional banks in the case of GCC countries and concluded
that the Islamic banks deposits and Islamic private credits are found to be relevant
determinants of economic growth and performed better compared to conventional
banks. Sukuk markets were not found to be relevant. Hachicha and Ben Amar (2015) and
Shabri et al. (2015) investigated the Malaysian case. The first paper used an augmented
neoclassical production framework and found the economic growth to be sensitive to
Islamic banking indicators in the short run, but less importantly in the long run. The
later supported the existence of the finance-growth led hypothesis between Islamic
financing and economic growth.
In addition to the contribution mentioned in the introduction, our research adds to the
literature in several ways: instead of linking asset or deposits to the economic growth,
we make use of the Islamic to conventional banking assets and deposits ratio in a panel
framework. Some of the papers published in this regard are either dealing with the
Malaysia case (Hachicha and Ben Amar, 2015; Shabri et al., 2015), the Malaysia and
Indonesia (Mohd. Yusof and Bahlous, 2013) case, the Middle east case (Grassa and
Gazdar, 2014) or are using total financing as proxy instead of the size or the presence as
is done in the present paper. However, our major goal is to assess how the structure of
the financial market influences the economic growth in Southeast Asian countries in the
short and long run.
3. Econometric methodology and data

3.1 Data
To investigate the impact of Islamic banking presence on the economic growth, the
following Southeast Asian countries are selected: Malaysia, Indonesia, Singapore,
Philippines, Thailand, Bangladesh and Brunei. The reasons behind choosing these
countries are size, maturity and global importance of their Islamic banking sector as
well as the availability and quality of data. This study focused on Southeast Asian
countries because it hosts financial markets with one of the most developed and
experienced Islamic banking sector in the world (Malaysia and Brunei) and a country
with the largest Muslim population (Indonesia). Malaysia is the first country to have an
Islamic banking sector in the actual standards, and today, it can be considered as the
host of the most mature Islamic banking system worldwide; Indonesia is the country
with the largest Muslim population in the world and, therefore, is the biggest market of
Sharia-based banking products[1]; Singapore is the financial heart of the region and is
competing to become the financial hub of Islamic banking in the region[2].
Empirically, the economic growth is measured as the log difference of the real gross
domestic product (GDP) per capita and serves as the explained variable. To represent
the financial system, the share in assets and deposits are used. The latter is used because
of the difference in the operating systems between Sharia-based banking and the
IMEFM conventional banking. What distinguishes Islamic banking from the traditional one is
9,4 the lending philosophy; although a loan in the conventional banking system is rewarded
a predetermined interest rate, in Islamic banking, the loan is conceived as equity based
on profit and loss and, therefore, no interest is guaranteed to the lending counterparty.
Hence, total deposits ensure the comparability of the two different banking systems.
The importance of deposits to the economy, in general, and the bank itself, in particular,
556 has been established in the literature by Hassan et al. (2011) and other studies.
For a bank, having more deposits means holding more for lending, which results in
an increase in consumption and investment and, ergo, higher GDP. Thus, deposits are
expected to positively influence the economic growth. As a robustness check, the asset
shares of the respective systems in the banking sector are used. The conditioning set
comprises inflation, government spending, trade openness, FDI and the high school
enrollment, which were used as macroeconomic control variables; we also use the rural
population as a control variable to give insight about the geographical barriers to the
delivery of financial services and to control Islamic banking development. Table I
succinctly presents the variables used in this study. A balanced panel was used
comprising the seven countries under investigation for the period ranging from 2000 to
2012 on a quarterly basis; descriptive statistics are given in Table II. To check for the
collinearity, the pairwise correlation coefficients between the independent variables
were calculated and reported in Table III. A correlation coefficient of less than 0.7 means
that variables are not correlating, which means there is no multicollinearity.
3.2 Econometric methodology

In addition to the numerous advantages that panel data estimation has over the mere
time-series or cross-sectional study, this study is based on fixed and dynamic panel
models to avoid unbiased and inconsistent estimates in the case of fixed effects. As
Baltagi (2001) advocated, panel studies are preferable to ordinary time-series studies
because of better variability, information, efficiency, larger degrees of freedom and less
collinearity. The direct relationship between economic growth and the financial
development is assessed using a regression specification in which the dependent
variable is the growth rate of the GDP per capita, and the explanatory variable is the
banking systems proxies for both conventional and Islamic sectors. To assess
stationarity, in general, unit root tests are conducted. Because the time-series unit root
test underperforms in panel data, panel unit root tests are used instead. From the
multitude of tests available in the literature (Levin et al., 2002; Im et al., 2003; Hadri, 2000;
Breitung, 1999), we opt for the Fisher unit root test by Choi (2001) because it does not
require balanced panel data.
In the second step, we check for the existence of a the long-term relationship between
the variables understudy; the framework proposed by Pedroni (1999) is applied in this
study because it deals with the spurious regression while allowing heterogeneity
between panel countries; furthermore, it allows for unbalanced structure as well as the
heterogeneity of slope coefficients along cross-sections. The Pedroni (1999) model starts
by estimating the residuals of the long-run model:
m
yit i
j1
it xit it (1)
Variable Name Definition Source
Islamic
banking
Dependent variable presence
Economic growth g Log difference of the real GDP World Bank
per capita
Independent variables
Assets ratio AR Ratio of Islamic to conventional Bank level data gathered by 557
banking assets authors from individual banks
and central banks augmented
with Bankscope data, where
available
Deposits ratio DR Ratio of Islamic to conventional Bank level data gathered by
banking deposits authors from individual banks

and central banks augmented
with Bankscope data, where
available
Control variables
Initial income rgdp The year beginnings real GDP The International Macroeconomic
Data Set
Inflation inf Inflation rate International Financial Statistics
(IFS)
Trade openness tot Exports and imports to GDP World Bank
Human capital H High school enrollment rate World Bank and UNESCO
database
Government gov Government spending to GDP World Bank
FDI fdi Foreign direct investment to World Bank and countries reports
GDP
Rural population rp Rural population percentage to World Bank and Bloomberg
total population
Muslim mp Percentage of Muslims in the Acemoglu et al. AER (2008)
population total population income and democracy data
Interaction mp AR Interaction term between Authors calculations Table I.
Muslim population and Variables and
banking ratio sources
where the error term can be decomposed into it iit wit . The null hypothesis is no
cointegration exists when i 1,i of the panel[3]. The second model used in this regard
is the one proposed by Westerlund (2007), which is a cointegration technique based,
rather on structural dynamics, that on the residuals, as proposed by Pedroni (1999). His
error correction model allows for heterogeneity between long-run cointegrating vector
for variable at level and the short-run dynamic for first-differenced variables and allows
for dependence between cross-sections while controlling for the panel heterogeneity
both in the short and long run.
yit c i1yit1 . . . ipyitp i0xit i1xit1

. . . ipyitp i(yit1 ixit1 ) it (2)
IMEFM Variable Observation Mean SD Minimum Maximum
9,4
Deposits ratio 364 0.12 0.23 0.00 1.63
Assets deposits 364 0.13 0.25 0.00 1.57
Economic growth 364 1.03 0.03 0.94 1.15
Government spending 364 0.11 0.05 0.05 0.29
558 Rural population 363 0.21 0.23 0.00 0.77
Human capital 364 0.77 0.18 0.45 1.12
Inflation 364 0.04 0.03 0.02 0.13
Table II. Trade 364 0.24 0.03 0.19 0.33
Summary statistics FDI 364 0.04 0.06 0.03 0.28
Variable AR DR rgdp g fdi Inf tot gov H rp
Assets ratio (AR) 1

Deposits ratio (DR) 0.96 1
GDP per capita (rgdp) 0.10 0.06 1
GDP growth (g) 0.32 0.27 0.11 1
FDI (fdi) 0.21 0.19 0.51 0.23 1
Inflation (Inf) 0.20 0.17 0.39 0.10 0.26 1
Trade openness (tot) 0.65 0.58 0.12 0.32 0.31 0.21 1
Table III. Government (gov) 0.40 0.36 0.36 0.23 0.09 0.49 0.53 1
Correlation matrix Human capital (H) 0.34 0.30 0.74 0.11 0.34 0.51 0.37 0.64 1
between variables Rural population (rp) 0.23 0.19 0.35 0.25 0.37 0.12 0.06 0.34 0.59 1
The speed of adjustment is determined by the error correction term; it determines

the speed of convergence toward the long-run equilibrium value i. If the null of no
error correction is rejected (i.e. i 0 ), the null hypothesis of no cointegration is also
rejected.
For the short-run and long-run estimations, we use the PMG and the MG techniques,
both proposed by Pesaran et al. (1999). The PMG is a dynamic error correction-based
technique that imposes fixed identical long-run coefficients or elasticities and allows
variation across the panel units (cross-sections) in the short run.
p q l
yit it yi,tj
j0
=it xi,tj
j0
F
j0
it i,tj it i t it (3a)
yi i( yi,t1 ixi ) 1ixi it i (3b)
The model is written as an auto-regressive distributed lag model of order ( p, q, , l), as

in equation (3a). By taking into consideration that the convergence factor is
incorporated, we get equation (3b), where yit, xi,tj and Fi,tj are the economic growth and
the Islamic to conventional banking share; t accounts for the short-run dynamics of y
across countries. The null being the coefficient of the first lag of both y and F. As
explanatory variables are equal to zero (H0: =1 1 0), the alternative is that both
coefficients are different than zero (H1: =1 0 or 1 0).
The MG estimator is based on the computation of a mean of the estimated values per Islamic
cross-section, and no restriction is imposed on the panel as a whole, and the banking
cross-section, thus, may vary freely. In the long run as in the short run, the coefficients
are heterogeneous, and a relatively large time-series observations is required[4]. The
presence
dynamic fixed effect of Pesaran et al. (1999) is also used. This model does not differ much
from the PMG approach because the slope coefficients are not permitted to vary along
cross-sections in the long run; however, each countrys estimated equation is entitled to 559
its own intercept; the dynamic fixed effect (DFE) model requires the short-run
coefficients to equate the speed of adjustment[5].
3.2.1 Sensitivity analysis. Maddala and Kim (1999) compared the ordinary least
squares (OLS), fully modified least squares (FMOLS) and 2SLS estimations in the
case where series exhibit unit-root and found that the 2SLS estimator exhibits
consistently low risk compared to all three cases. The fixed-effects instrumental
variables estimation called the 2SLS model is used to check for the consistency of
our findings. Imam and Kpodar (2010) argued in their study that the share of Muslim
population explains the Islamic banking diffusion.
The 2SLS approach used the estimated value of the explanatory variable instead of
the real values. The fitted values are estimated in the first stage with a explanatory
variable, a set of control variables and an instrument variable. The latter is used to
address the problem of omitted variables bias and the simultaneity problem that occurs
when two variables are determined simultaneously (Angrist et al., 2000). The
fixed-effect estimator is used because it presents the advantage of controlling for
country characteristics and, in contrast to the between estimator, uses all observations
of the data set and its developments over time.
4. Empirical results
4.1 Panel unit root test and cointegration analysis
Table IV presents Fisher panel unit root test (Choi, 2001), where variables are first tested
both in levels and at first difference. A time trend was included in the test specification,
and the optimal lag length was defined using Schwarz (1978) information criterion.
Results in Table IV clearly show that when the variables are taken at level, the unit-root
Level First difference

Variable Fisher 2 p-value Fisher 2 p-value
Real GDP 4.12 0.99 299.52*** 0.00

Islamic banking assets ratio 9.67 0.79 144.95*** 0.00
Islamic banking deposits ratio 9.80 0.78 128.28*** 0.00
Foreign direct investment 50.37*** 0.00 56.83*** 0.00
Inflation 45.32*** 0.00 86.88*** 0.00
Trade openness 15.95 0.32 118.26*** 0.00
Government spending 6.73 0.94 54.76*** 0.00
Human capital 9.75 0.78 44.15*** 0.00
Rural population 6.08 0.96 146.13*** 0.00 Table IV.
Results of the Fisher
Notes: *** , ** and * denote significance at 10, 5 and 1 per cent, respectively; for Fisher unit root test, panel unit root test:
the null all series have a unit root pattern, and the alternative states that some cross-sections do not have variables at level and
a unit root pattern; the Fisher test considers individual unit root assumptions first difference
IMEFM hypothesis cannot be rejected, but when using the variables at first difference,
9,4 stationarity occurs. Actually, the stochastic series at level follow random walk processes
and, hence, regression using variables at level will yield unreliable coefficient unless the
variables are found to be cointegrated.
The long-run relationship between the growth of real GDP and the Islamic
banking presence translates through the examination of cointegration among the
560 variables. When variables are integrated in the same order, stationary at the same
level, a linear combination of the integrated variables can still be stationary for the
panel and three statistics for the group mean panel cointegration and the
residual-based methodology which deals with the heterogeneous panels (Baltagi,
2001). Cointegration was assessed by the methods devised by Pedroni (1999) and
Westerlund (2007)[6].
Table V shows Pedronis cointegration test results; the null of the absence of
cointegration is rejected when the test statistic lacks significance[7]. Both panel-
and panel-PP statistics reject the null of no cointegration between Islamic banking
deposits ratios and the economic growth, and the all-group mean cointegration
statistics fail to reject the null of the absence of a long-run relationship. As far as the
conventional bank deposits are concerned, the panel statistics show, unanimously at
1 and 5 per cent significance level, that at least a cointegration relation exists
between the economic growth and the conventional banking deposits in the panel;
the group PP statistic proposes rejection of the null at 10 per cent level of
significance. For the deposits ratio model, the null of the absence of long-run relation
is rejected at 1 to 5 per cent significance level for the panel only. We check for these
results using the Westerlund (2007) error correction method-based test, and results
are reported in Table VI, with p-values of one-sided cointegration tests based on the
bootstrapped distribution. The rejection of the null in the case of the Ga-statistic and
Gt-statistic is an evidence of the existence of cointegration in at least one of the
cross-sections of the panel. Whereas, the rejection of null for the Pa-statistic and
Pt-statistic shows that, when all the cross-sections are taken as a pool, the
cointegration between Islamic banking ratio and economic growth is confirmed. The
Assets ratio Deposits ratio

Statistic Probability Statistic Probability
Panel cointegration statistics

Panel 2.239** 0.013 2.912*** 0.002
Panel 2.094*** 0.009 1.940** 0.026
Panel PP 2.554*** 0.005 3.041*** 0.001
Panel ADF 2.377*** 0.009 2.552*** 0.005
Group mean cointegration statistics
Group 1.623* 0.091 0.371 0.355
Group PP 2.597*** 0.005 1.552* 0.060
Table V. Group ADF 2.453*** 0.006 0.122 0.452
Panel cointegration
test: Pedroni Notes: * , ** and *** denotes significance at 10, 5 and 1 per cent, respectively; the H0 of Pedroni test
estimation is no cointegration; p-values denote marginal significance levels
Deposits ratio Assets ratio
Islamic
Statistic z-ratio Probability Statistic z-ratio Probability banking
presence
Cross-sections
Gt statistic 3.150*** 3.74 0.000 2.901*** 3.06 0.000
Ga statistic 15.503*** 3.76 0.000 14.158*** 3.16 0.000
561
Panel
Pt statistic 6.739*** 6.74 0.001 8.452*** 8.45 0.000
Pa statistic 13.085*** 13.09 0.000 18.878*** 18.88 0.000
Table VI.
Notes: *** , ** and * denote significance at 1, 5 and 10 per cent, respectively; the lag and lead lengths Panel cointegration
were set to 4 and the width of the Bartlett kernel window was set to 2; the p-values and z-value reported test: Westerlund
in the table are acquired by bootstrapping using 300 replications estimation
reported regressions are the results of 300 bootstrap replications. The ratio of
Islamic banking deposits and assets is cointegrated with the economic growth,
which is an evidence of a long-run relationship between Sharia-based banking, both
in terms of assets and deposits. We verify these results henceforth using causality
estimations.
4.2 Heterogeneous causality: granger-causality estimation

The causality between the economic growth and financial development may vary
from country to country, as it might be similar across countries. Many authors
proposed the use of Granger-causality test, but the non-stationarity of the
explanatory variables renders the causality estimation non-reliable. Because, in the
present panel, the variables are found to be non-stationary but cointegrated, it is
pertinent to use an error-correction model in examining the causal links among
variables. We supplement this analysis by the results of PMG and MG estimators.
For the lag-length selection in the PMG model, Bayesian criterion is used. Table VII
reports the results of PMG, MG and DFE. In the long run, results show positive and
statistically strong, although low, coefficients and, therefore, limited impact of
Islamic banking assets and deposits ratios with 0.74 and 0.02, respectively. The MG
estimation could not corroborate this finding though, whereas the results of the DFE
model show a weak negative impact on the long run. An increase by 1 per cent point
in Islamic to conventional banking depositss ratio leads to 0.74 per cent increase in
the GDP growth, whereas the same increase in assets share ratio yields an increase
of 0.02 per cent in the GDP growth; for the short-run coefficients, however, results
lack statistical significance. The error correction term is negative and significant,
implying that in the short run, as shown by the MG model, convergence toward
equilibrium is expected at a speed varying from 6 to 36 per cent per quarter. We use
the Hausman test to check for systematic differences between PMG and MG, then
between PMG and DFE coefficients. Results show that at 10 per cent significance
level, the null hypothesis of the homogeneity of the long-run coefficients cannot be
rejected; the PMG estimators are, hence, consistent and more efficient than MG
estimators in both models specifications, that is, the panel results are homogeneous
in the long run but not in the short run. Results of the PMG show a positive
9,4
562
Results of
estimation
IMEFM
Table VII.
cointegration
PMG MG DFE
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Long run
FDI 1.09*** 5.57*** 0.47*** 0.30 1.26 0.47 0.23** 0.23** 0.35
Inflation 0.02 3.84*** 0.03 0.02 1.05 0.01 0.27* 0.27 0.18
Trade 5.23*** 0.12*** 2.85*** 2.75 5.42 0.11 0.42 0.41 4.17
Government 2.74 7.16*** 2.39 0.47 4.13** 4.19 0.39 0.35 1.84
Human capital 0.71*** 1.23*** 0.80*** 2.33 0.62 1.34** 0.06 0.06 0.32
Rural population 0.17 4.98 1.65** 8.22 7.44 0.39 0.15 0.22 4.62
Ratio deposits 0.74*** 0.41 0.01
Ratio assets 0.02*** 0.02 0.03*
Short run
Error correction 0.06* 0.06 0.21 0.24*** 0.28*** 0.36*** 0.19*** 0.19*** 0.16**
D.FDI 0.35 0.75* 0.50 0.55 0.56 0.50 0.12*** 0.12*** 0.20***
D.inflation 0.13 0.03 0.29** 0.07 0.02 0.04 0.03 0.03 0.06
D.trade 0.36 0.12 0.32 0.09 0.06 1.48 0.27 0.27 0.56
D.government 0.40 0.01 1.07* 0.10 0.12 0.85* 0.30 0.27 1.13
D.human 0.11 0.49 0.11 0.56 0.31 2.67 0.12 0.13 0.16
capital
D.rural 0.33 0.41 0.06 0.15 0.63 0.04 0.05 0.04 0.16
population
D.ratio 0.95 0.12* 0.01
deposits
D.ratio assets 0.00 0.01 0.01***
Constant 0.00 0.06 0.03 0.17 0.20 0.24** 0.18*** 0.18*** 0.13
Notes: For t-statistic; * , ** and *** denote significance at 10, 5 and 1 per cent, respectively; z-statistic for the PMG and PM and t-statistic for DFE; the
used regression routines control for time and country effect in all PMG, PM and DFE estimations; D.variable implies first difference
explanatory power of Islamic banking presence on the economic growth in the long Islamic
run. This positive impact is true for both assets and deposits ratios throughout banking
different model specifications and is statistically significant, in contrast to the presence
short-run coefficients where no significant relation was established. The obtained
results corroborate the findings of Grassa and Gazdar (2014) and Farahani and
Dastan (2013b) in the case of GCC countries, but are not in line with Hachicha and
Ben Amar (2015), in the case of Malaysia, where only short-run relations were 563
significant, highlighting the importance of a case-by-case analysis[8].
4.2.1 Sensitivity analysis: 2SLS, fixed effect (FE) and random effect (RE). Angrist
et al. (2000) argued that the main explanatory variable of the presence of Islamic banking
was the share of Muslim population, and Imam and Kpodar (2010) suggested that the
Muslim population share in the total population is an appropriate exogenous instrument
to cope with the endogeneity issue and is therefore used in this section as an
instrument[9]. Table VIII reports estimations of the second stages of the 2SLS, and
results reveal that the higher the share of deposits and assets, the higher the economic
growth; therefore, we confirm the findings of Imam and Kpodar (2010) that Muslim
population is the primary reason for the presence of Sharia-based banking. System
generalized method of moments (GMM) is used as robustness check and confirms these
findings.
Results of the FE and RE estimations are reported in Table IX; the ratio of Islamic to
conventional financial institutions enters the estimated equation with a positive sign in
both FE and RE specifications. The coefficients of the share of Islamic bank deposits is
positive and statistically significant in all model specifications, whereas the ratio of
Islamic bank assets is negative in all models, except in the two models where the
interaction term between Muslim population and the share of Islamic banking is
introduced as a variable. The significance of the interaction term implies that the
response of the dependent variable to the independent variable differs at different values
of the other dependent variable. In regressions without an interaction term, the Islamic
banking presence is found to fail to improve the economic growth, in other words, it
failed to improve competitiveness and efficiency and, therefore, failed to hasten the
economic growth in the whole region. These results change as soon as we add the
interaction term; the coefficient of Islamic banks becomes positive and so does
the interaction term. Hence, we conclude that countries with a higher share of Muslims
is a propitious environment and a good incubator for Islamic banks to improve economic
development, but in countries with less Muslim population, the presence of Islamic bank
impacts the economic growth to a lower extent. In other words, the impact of Islamic
banks relys on the importance of costumers with Islamic background. Statistical
significance suggests that initial output is converging in the random effect model; the
government spending, inflation and the rural population portion negatively affect the
economic growth; the FDI and, to a lesser extent, trade boost the economic growth in our
model. GMM-based results, therefore, corroborate the findings of the 2SLS results and
thereby the relevance of the structure of the financial system to the economic growth.
Hausman test shows preference to the fixed-effect model because the probability of 2 is
less than 10 per cent; therefore, we conclude that heterogeneity across panel units does
influence the interaction between the financial market structure and the economic
growth.
9,4
564
estimations
IMEFM
Table VIII.
system GMM panel

Two-stage OLS and
GMM 2SLS
(1) (2) (3) (4) (5) (6) (7) (8)
L.lnrgdp 0.062 0.016* 0.010 0.003 0.009*** 0.002 0.006 0.022

Inflation 0.198 0.039 0.057 0.181** 0.038 0.186** 0.154 0.167*
FDI 0.149 0.318*** 0.326*** 0.299*** 0.137*** 0.266*** 0.267*** 0.261***
Government 0.049 0.069*** 0.042 0.002 0.003 0.002 0.002 0.002
Trade 0.061* 0.065*** 0.019 0.018 0.021*** 0.010 0.001 0.007
Rural population 0.060 0.058 0.165 0.133*** 0.001 0.039 0.092* 0.163***
Human capital 0.201 0.035 0.046 0.008 0.043** 0.011 0.001 0.024
Interactiona 0.002 0.001 0.003* 0.005** 0.004* 0.004**
Deposits ratio 0.143* 0.114
Assets ratio 0.317*** 0.503***
Muslim population 0.062** 0.008 0.073
Constant 0.445 0.691*** 0.755*** 1.006*** 1.151*** 1.072*** 1.027*** 1.041***
N 357 95 95 95 357 95 95 95
AR1 p-value 0.22 0.00 0.01 0.01
AR2 p-value 0.67 0.33 0.43 0.70
Sargan p-value 0.07 0.00 0.99 0.00
Notes: * , ** and *** denote significance at 10, 5 and 1 per cent, respectively; the Islamic to conventional ratio coefficient enters the second stage as the estimated
value from the first-stage regression; the over-identifying restriction test is represented by p-value of Sargan statistic; a Interaction stands for the interaction
between Muslim population and Islamic banking ratio (Muslim population banking ratio)
FE RE
Islamic
(1) (2) (3) (4) (5) (6) (7) (8) banking
presence
L.lnrgdp 0.11** 0.08 0.01 0.12** 0.01 0.03*** 0.01*** 0.00
Trade 0.03 0.05* 0.01 0.04 0.02 0.03 0.01 0.02
FDI 0.24*** 0.22*** 0.20*** 0.20*** 0.20*** 0.24*** 0.12*** 0.29***
Government 0.01 0.02 0.04*** 0.00 0.02 0.02 0.01 0.00
Inflation 0.23** 0.30*** 0.16** 0.23** 0.08 0.24*** 0.05 0.21**
565
Human
capital 0.02 0.03 0.02 0.08 0.03 0.01 0.02 0.02
Rural
population 0.16** 0.22*** 0.03 0.36*** 0.00 0.09** 0.04* 0.14***
Deposits
ratio 0.01* 0.02*** 0.00 0.02***

Interactiona 0.02*** 0.01*** 0.02*** 0.00*
Assets ratio 0.01 0.61*** 0.03*** 0.33***
Constant 0.12 0.48 0.79*** 0.02 1.03*** 1.34*** 1.11*** 1.00***
Hausman 11.93* 4.96 15.82** 15.10**
Hausman
p-value 0.06 0.66 0.02 0.05
Table IX.
Notes: * , ** and *** denote significance at 10, 5, and 1 per cent, respectively; robust standard errors Fixed effect and
are reported in parentheses; a interaction stands for the interaction between Muslim population and random effect
Islamic banking ratio (Muslim population banking ratio) estimations
5. Conclusions
We assessed and evaluated the relationship between economic growth and the share of
Islamic banking in the financial market of Southeast Asian countries in terms of assets
and deposits. Results show that a long-run relationship exists between both ratios of
assets and deposits and economic growth. We conclude that a large size of Islamic
banking sector is associated with a higher economic growth, which is considered as a
consequence of the financial deepening. The same conclusion was obtained when we
substituted assets for deposits as a regressor. This shows that Sharia-compliant banks
succeed in mobilizing additional resources for the financial sector, which may increase
the stability of the banking system and the efficiency of the whole banking sector, as
suggested by Beck et al. (2013) and Lebdaoui and Wild (2016). Economic growth
resulting from the increase of Islamic banking assets share can also be justified by the
risk limitation imposed by Sharia-compliant banking products in a time of global
financial meltdown.
The sensitivity analysis conducted using GMM and 2SLS models corroborate these
findings. However, in the short run, no statistically significant results are found, which
suggests that it may take some time until the influence of Islamic banking translates into
long-run economic growth, i.e. the results predict that short-run benefits may be limited,
but significant, in the long run. We believe that the inclusion of this financial system will
stimulate financial deepening and, moreover, improve financial stability because of
portfolio diversification in the countries under investigation as well as all other
countries with significant Muslim population. Moreover, we conclude that the presence
of Islamic banking plays a significant role in stimulating growth in a heterogeneous
IMEFM manner across countries because of the presence of the fixed effects which are justified
9,4 by the multifarious economic structures across the Southeast Asia (SEA) region,
financial market size and the proportion of Muslims in the population. Hence, our
findings suggest that governments in these countries can promote Islamic banking to
mobilize dormant funds and inject it to the financial sector and consequently foster
capital allocation, innovation and, eventually, per capita economic growth. The
566 importance of the share of Muslim population as a pivot of Islamic banking contribution
on economic prosperity is also a key finding.
As a policy recommendation, our results suggest that governments should
permit, if not encourage, financial deepening by allowing Islamic banking products
and operation, thus including the portion of the unbanked Muslim population in the
financial system. Future research should shed more light on this topic, especially
with respect to the causes of heterogeneity amongst countries with respect to the
size, structure and depth of different financial systems with Islamic banks around
the world.
Notes
1. Indonesia accounts 205 million Muslims according to the Pew Forums 2011report on the
worlds Muslim population Pew Research Centers Forum on Religion & Public Life.
2. Data on deposits were not readily available, and data collection required a personalized
data collection starting from finding the exhaustive list of Islamic banks in a given
country and getting archived reports from single banks, provided, in many cases, in local
language. Because of these reasons and mainly because of the time constraint, decision
was made to keep only SEA countries and sacrifice the volume against results reliability.
3. For the panel cointegration statistics, the alternative H1 is i 1,i, i 1, 2, 3, . . ., n . The
group mean panel cointegration statistics allows for heterogeneity, and the alternative
hypothesis is given by H1: i 1,i, i 1, 2, 3, . . ., n.
4. The Hausman (1978) test is used to test the poolability option of data against estimating each
cross-section as an independent sampling unit separately. The test is based on the difference
between PMG and MG estimators and checks for the long-run homogeneity.
5. The most recent technique that has been widely used in the recent years for the economic growth
model is the GMM. However, Roodman (2006) expressed his reluctance to use the GMM estimator
in the case were N is smaller than T, because of the likely inference of spurious estimations
resulting from the increase of the number of instruments (which is originated by the increase of
cross-sections) on one hand and the unreliability of autocorrelation test results and, therefore,
compromising the Sargan test results on the other hand.
6. Statistics proposed by Pedroni (1999) are as follows: pooled variance ration statistic
(non-parametric), pooled -statistic (semi-parametric), pooled t-statistic (semi-parametric),
pooled t-statistic (parametric), group mean rho-statistic (semi- parametric), group mean
t-statistic (semi-parametric) and group mean t-statistic (parametric). For the case of Pedroni
test, Bayesian information criterion is used (Schwarz, 1978) to automatically select the
appropriate lag length.
7. The cointegration test proposed by Pedroni (1999) reports seven statistics (, , PP and ADF
statistics where homogeneity of the group is assumed and , PP and ADF in the second part
assumes independence between groups).
8. Dummies for crisis years were introduced, but the coefficients and significance levels were not Islamic
substantially different between models, and none of the dummies had a statistically
banking
significant relationship with the dependent variable and, therefore, were removed. F-test
statistics were not significantly different among the models. One explanation for this could be presence
that the subprime crisis stared to impact SEA countries after 2008, for some countries 2009 or
even 2010. The exact year or period of crisis is, therefore, not clearly defined. Several studies
concluded that Islamic banks or countries with significant Islamic banking presence were 567
resilient to the financial crisis (Abduh et al., 2011; Hasan and Dridi, 2011). Further studies may
shed light on this issue.
9. The reported F-statistic is significant; therefore, the Muslim population is an exogenous valid
parameter to be used as an instrument in the first-stage regression.
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Corresponding author
Hind Lebdaoui can be contacted at: h.lebdaoui@aui.ma
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Islamic banking presence and Islamic

School of Finance, Shanghai University of Finance and Economics,

3. Econometric methodology and data

3.2 Econometric methodology

banking deposits authors from individual banks

yit c i1yit1 . . . ipyitp i0xit i1xit1

Variable AR DR rgdp g fdi Inf tot gov H rp

Assets ratio (AR) 1

The speed of adjustment is determined by the error correction term; it determines

yi i( yi,t1 ixi ) 1ixi it i (3b)

The model is written as an auto-regressive distributed lag model of order ( p, q, , l), as

Level First difference

Real GDP 4.12 0.99 299.52*** 0.00

Assets ratio Deposits ratio

Panel cointegration statistics

in the table are acquired by bootstrapping using 300 replications estimation

4.2 Heterogeneous causality: granger-causality estimation

system GMM panel

L.lnrgdp 0.062 0.016* 0.010 0.003 0.009*** 0.002 0.006 0.022

ratio 0.01* 0.02*** 0.00 0.02***

Association, Vol. 46 No. 6.

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ratio 0.01* 0.02* 0.00 0.02*