The Flow of Islamic Finance and Economic Growth: an Empirical Evidence of Middle East

Islamic finance is one of the fastest growing sectors of the global banking industry and has risen to prominence recently through its distinctive characteristics. The emergence of Islamic finance can be traced back to 1963 in Egypt, while its importance comes to the global financial system only after the global financial crisis occurred in 2008. This paper explores empirically the relationship between the development of Islamic finance and economic growth in the Middle East. Three of the most important countries for Islamic finance growth from Middle East, namely Qatar, Bahrain, and United Arab Emirates (UAE), are selected for the study. To document the relationship between development of Islamic finance and economic growth, annually time-series data of economic growth and Islamic banks’ financing were used. We use Islamic banks’ financing credited to private sector through modes of financing as a proxy for the development of Islamic finance system and Gross Domestic Product (GDP), as a proxy for economic growth. For the analysis, the unit root test, co-integration test and Granger causality tests were done. Our empirical results generally signify that in the long run Islamic banks’ financing is positive and significantly correlated with economic growth in the select countries which reinforces the idea that a well-functioning banking system promotes economic growth. The results obtained from Granger causality test reveals a causal relationship between Islamic finance and economic growth in these countries. It is neither Schumpeter’s supply-leading nor Robinson’s demand-following. It appears to be a bi-directional relationship from Islamic banks’ financing to economic growth and vice versa for Bahrain and Qatar. The results obtained from Granger causality test for UAE indicates that a causal relationship happens only in one direction, i.e., from Islamic banks’ financing to economic growth, which supports Schumpeter’s supply-leading theory. Our results also indicate that improvement of the Islamic financial institutions in the Middle East countries will benefit from economic development, and it is important in the long run for the economic welfare, and also for poverty reduction. Furthermore, the results of study are quite significant as it is one of the pioneering studies of Islamic finance.