Growth of a Country and Islamic Banking

Since the modern birth of Islamic banking in the 1970s in Egypt, it has expanded rapidly across the globe. As illustrated by Imam and Kpodar (2013), such expansion has taken place, in particular—though not exclusively—in countries with larger Muslim populations. From an insignificant beginning, the industry has grown to over USD 2.5trillion in assets in 2021, and is expected to reach USD 6.1 trillion by the end of this decade. Not only have local banks in Muslim countries adopted Islamic banking principles, but large multinational banks have established Islamic windows. Islamic finance has spread beyond commercial banks, and now spans investment banks, insurance companies, as well as investment (e.g. asset management) and financial companies (e.g. leasing). The development of new products, such as sukuks (Islamic bonds), has also broadened the range of products available.

There is mounting evidence—at least for lower and middle income countries—that financial sector development is good for growth. A developed financial sector helps mobilize savings, facilitates the allocation of capital to where returns are expected to be highest, monitors the use of capital once invested, and allows for diversification of risk. Moreover, there is a growing consensus among economists that it does not matter much for economic growth whether the financial system is more bank-based or market-based. The particular institutional arrangements that provide financial services to the economy are not so important; what matters is the level of overall financial development.

However, do these findings of financial sector deepening impacting growth also apply to systems where Islamic banking plays a significant role? This is an important question to answer, as with a few exceptions, countries with large Islamic populations are typically not highly developed, and have often not performed well in economic terms, one of the reasons being an underdeveloped financial system.

Thus, the rapid diffusion of Islamic banking represents a growth opportunity for Islamic countries, as much of the empirical evidence suggests a strong link between financial sector development and growth. However, the empirical literature has only looked at conventional banking, not Islamic banking. Thus by researchwe have to rectify this lacuna, by considering whether Islamic banking is also potent in raising growth. Here we have to establish the positive relationship between Islamic banking and economic growth, and not to answer the question of whether the growth-enhancing effect of Islamic banking goes beyond that of conventional banking. Using a sample of low- and middle-income countries with data over the period 1990-2021, we investigate the impact of Islamic banking on growth and can discuss the policy implications. The results show that, notwithstanding its relatively small size compared to the economy or the overall size of the financial system, Islamic banking is positively associated with economic growth even after controlling for various determinants, including the level of financial depth. The results are robust across different measures of Islamic banking development, econometric estimators (pooling, fixed effects and System GMM), and to the sample composition and time periods.

The objective here is to assess the impact of Islamic banking on economic growth. For comprehensive assessment robust empirical techniques are required to be used. We find that, holding constant the level of financial development and other growth determinants, countries where Islamic banking is present and hence its impact on growth is measurable, experience faster economic growth than others. This is a powerful result, and robust to various specifications: we use different measures of Islamic banking development, econometric estimators (pooling, fixed effects and System GMM), and control for country and time-specific dummies. This finding is also encouraging as, despite its rapid growth, Islamic banking still represents a relatively small share of the economy and of the overall size of the financial system, and it has yet to reap the benefits from economies of scale. Although we cannot suggest that Islamic banking provides 23 more “bang for the buck” compared to conventional banks; it does, however, establish the positive impact on growth. As indicated, there are uncertainties on the magnitude of the growth effect of Islamic banking, which calls for further research as Islamic banks diffuse further and become larger. Should future studies confirm this finding, the policy implications would be significant.

As the global crisis has illustrated, conventional banking has many weaknesses—its excessive dependence on leverage being one of them. However, Islamic banking, which is one of the fastest growing segments of global finance, has unique features that are highly appropriate for developing countries. In particular, it is based on risk-sharing, making its activities more closely related to the real economy than conventional finance; it is also more flexible against shocks and more inclusive with regards to growth. Not only does Islamic finance help to stimulate growth, but it also appears less prone to risks such as bubbles (Dridi and Maher, 2011).

This means that many countries that currently suffer from low growth—a feature often present in Muslim countries—may want to further develop this segment of finance. As an initial step, it is essential to develop proper legislation and regulation, as well as the supporting infrastructure, including the necessary skill set. Future areas of research include measuring better Islamic banking development and assessing the impact of Islamic banking on inequality and social development.Growth in Islamic countries, while not spectacular, has not been dismal compared to other countries with a similar level of development. The widely held perception is that Islamic countries have performed poorly in economic terms since the 1950s, but this does not hold. After an initial strong growth spurt following independence—in sync with other low-income countries (LICs)—growth rates were sub-par following the lost decades of the 1980s and 1990s. While it is true that Islamic countries and sub-national regions with large Muslim populations are characterized by low incomes and a low level of social development, with the exception of oil-producing Gulf countries, they are in fact not much different from other emerging markets (EMs) and LICs. In fact, once adjustments for low education levels, poor institutions, commodity prices, etc., are made, evidence is mounting that Islam per se is not holding back these countries (Nolan, 2003).

Similarly, Islamic countries do not currently stand out in terms of private sector credit to GDP. However, as Islamic banking becomes more acceptable to a large swath of the population, it could expand faster, as it would not necessarily be a substitute for conventional banking, but it would provide financial products to a part of the population that otherwise would not use the financial system, potentially leading to higher financial inclusion and an acceleration of economic growth in these countries.