Financial development, Islamic finance and economic growth: evidence of the UAE

Journal of Islamic Accounting and Business Research
Financial development, Islamic finance and economic growth: evidence of the
UAE
Hajer Zarrouk, Teheni El Ghak, Elias Abu Al Haija,
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Vol. 8 Issue: 1, pp.2-22, https://doi.org/10.1108/JIABR-05-2015-0020
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Financial development, Islamic
finance and economic growth:
evidence of the UAE
Hajer Zarrouk
Emirates College of Technology, Abu Dhabi, UAE and
PS2D, Faculty of Economics Sciences and Management,
University Tunis El Manar, Tunis, Tunisia
Teheni El Ghak
Faculty of Economic Sciences and Management of Tunis,
University of Tunis El Manar, Tunis, Tunisia, and
Elias Abu Al Haija
Department of Banking and Finance, Emirates College of Technology,
Abu Dhabi, UAE
Abstract
Purpose – Does Islamic finance affect economic growth? The empirical literature in this area seems to
be in early stages and the results are often mixed and inconclusive. This paper aims to examine the
causality between financial development in general, Islamic finance in particular and real economic
growth in the United Arab Emirates (UAE).
Design/methodology/approach – Using time series data from 1990 to 2012, a bivariate vector
autoregressive model was used to document the financial development-Islamic finance-growth causal
nexus and to forecast growth under various scenarios. A composite indicator, as a proxy for financial
development, was determined using a non-parametric approach: data envelopment analysis.
Findings – The direction of causality runs from financial development to economic growth and the
reverse causality does not drive this relationship; however, the real gross domestic product (GDP) causes
Islamic financial development with no reverse effect. Furthermore, the forecasting results indicate that
the past relation has been a proxy for the future where financial development leads to better progress in
real economic activity. This will likely continue to stimulate the development of Islamic finance.
Research limitations/implications – Because the financial markets in the UAE were established in
2000, this study ignored Islamic bonds and equity product. The value of the Sukuk listed on Dubai’s
exchanges is around US$36.75bn (Thomson Reuters, 2015), reinforcing Dubai’s position as an
international center for Sukuk activity. Among the most important tools of the Islamic financial sector,
Sukuk deserves a closer empirical study. This can set the agenda for future work.
Practical implications – The financial sector appears to be one of the main drivers of real economic
activity. However, more effort in the area of Islamic finance is needed to promote Shari’ah-compliant
economic activities and thus better contribute toward making Dubai-UAE the capital of the Islamic
economy.
Originality/value – A new indicator was used to evaluate the financial strength of the UAE and
analyze its effect on economic development. In addition, as one of UAE’ emirates, Dubai declared its
The authors would like to thank participants at The 2015 An Islamic Perspective of Accounting,
Finance, Economics and Management (IPAFEM) conference, University of Glasgow, UK, for their
comments and suggestions. The authors specially thank Dr Mohamed Sherif. The authors take
responsibility for any errors in the article.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1759-0817.htm
JIABR
8,1
2
Received 22 May 2015
Revised 2 October 2015
24 November 2015
6 January 2016
Accepted 6 January 2016
Journal of Islamic Accounting and
Business Research
Vol. 8 No. 1, 2017
pp. 2-22
© Emerald Publishing Limited
1759-0817
DOI 10.1108/JIABR-05-2015-0020Downloaded by RMIT University Library At 05:01 02 January 2018 (PT)

vision in 2013 to become the “capital of the Islamic economy”, this study analyzed the finance, Islamic
finance and growth relations over the period 2013-2022.
Keywords Islamic finance, Data envelopment analysis, Growth, Financial development, UAE,
bVAR
Paper type Research paper
1. Introduction
Economists have been interested in the role of expansion of financial institutions in resource
allocation and so in economic growth. Most researchers agree on the importance of the role of
the financial sector in real economic growth, both at the national and international levels
(Demirgüç-Kunt et al., 2004; Love, 2003). The financial sector plays a promotional role if it is
able to channel financial resources toward the industries with good growth opportunities.
When the financial sector is more developed, more financial resources can be allocated into
productive real investment and more physical capital gets formed, which will stimulate
economic growth.
In the past two decades, the Islamic financial industry has emerged through the world.
Global Islamic banking assets have been growing rapidly. According to the World Islamic
Banking Competitiveness Report 2014-2015, they attained a compounded annual growth
rate of around 17 per cent from 2009 to 2013. International Islamic banking assets with
commercial banks were set to exceed US$778bn in 2014. In particular, six markets – Qatar,
Indonesia, Saudi Arabia, Malaysia, the United Arab Emirates (UAE) and Turkey – are
heading toward touching US$1.8tn by 2019. The performance and relative stability of
Islamic financial institutions during the financial crisis that hit the world in 2008 increased
the demand for Shari’ah-compliant products, not only from financiers in the Middle East and
other Muslim countries, but also by investors around the world seeking Islamic investment
as a means of diversification.
How important is Islamic financial development for economic development? Several
theoretical studies have been undertaken in the different fields of Islamic banking. Most of
them indicate the superiority of the Islamic financial industry compared to the conventional
one in terms of stability and efficiency (Hasan and Dridi, 2010; Hanif et al., 2012; Mansor et al.,
2015). However, only few studies have searched for empirical evidence connecting Islamic
finance and economic growth.
Against this background, this study attempts to respond to the question:
Q1. Do financial development and Islamic finance stimulate the real economic activity of
the UAE?
In line with earlier studies, the present study closely examines the causality between
financial development and economic activity, but with some differences. First, previous
studies generally considered a sample of countries, including the UAE. These studies
provided a higher degree of generalization and not an internal validity specific to each
country, thereby increasing the need for country-specific studies. To the best of our
knowledge, studies in this area on the UAE are very few (Al-Malkawi et al., 2012; Tabash and
Dhankar, 2014).
Meanwhile, the UAE’s gross domestic product (GDP) in 2013 was US$396.24bn, making
it the world’s 27th largest economy. The contribution of the oil sector to the UAE’s GDP is
decreasing because the government is attempting to diversify its economy. The UAE has
embarked on an overall economic reform package that included policy and structural
reforms in the financial sector. The role of Islamic finance, as a segment of the global
financial system, has also been a key focus in development policy discussions. Therefore,
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focusing on the UAE economy in this study is significant. Second, previous studies generally
considered financial development or Islamic financing. In contrast, the present study
considers the role of financial development in general and Islamic finance in particular.
Third, while most of the empirical research has focused on single indicators of financial
development, this study mainly focuses on a composite index used to evaluate the financial
strength of the UAE. Fourth, economic forecasting has always been a central concern among
researchers and policy-makers. It helps to establish plans and formulate objectives. During
the past decade, the vector autoregressive model (VAR) has become the standard tool for
predicting economic activity. This study projects historical values of variables into the
future by using a VAR.
The rest of the paper is structured as follows: Section 2 presents the theoretical framework
whereby the relationship between financial development, Islamic finance and economic
growth is outlined. Section 3 describes the details of the data and the empirical approach used
in this study. Section 4 reports and analyzes the results. Section 5 contains the conclusion.
2. Theoretical and empirical framework
A brief overview is provided in this section to highlight the fact that Islamic financial system,
similar to the conventional one, performs broad functions that may influence saving and
investment decisions and hence could have implications for real economic growth. These
include the provision of external financing as described by Schumpeter (1912) – financial
institutions provide funding to entrepreneurs with good growth prospects. Any industry
with high growth opportunities will require a relatively large amount of outside financing.
Thus, the banking sector is considered an engine of economic growth.
Gurley and Shaw (1955), Goldsmith (1969) and Hicks (1969) have argued that more
developed financial markets promote economic growth by mobilizing savings and
facilitating investment. Mobilization may involve multiple bilateral contracts between
productive units raising capital and agents with surplus resources. To economize on the
costs associated with multiple bilateral contracts, pooling may occur through intermediaries,
where thousands of investors entrust their wealth to intermediaries that invest in hundreds
of firms (Sirri and Tufano, 1995). This takes place when mobilizers convince savers of the
soundness of the investments.
King and Levine (1993) emphasized the role of financial institutions in overcoming
informational problems. Indeed, there are large costs associated with evaluating firms,
managers and market conditions before making investment decisions. Individual savers
may not have the ability to collect and produce information on possible investments. Savers
will be averse to invest in industries having little reliable information. High information costs
may keep capital from flowing to its highest value use. Financial institutions producing
better information on firms will thereby find more promising investments, and induce a more
efficient allocation of capital and foster growth (Greenwood and Jovanovic, 1990).
In this line of thinking, Levine (1997) stressed that market frictions like information and
transaction costs motivate the emergence of a well-developed financial sector which can be
seen as well-offered financial services. Therefore, an increased financial service may affect
economic growth through two main channels: capital accumulation and technological
innovation (Figure 1).
In addition, as suggested by Rajan and Zingales (1998), certain industries have a lag
between investment opportunities and cash flow. Industries with this inherent need for
external finance will respond to growth opportunities in countries with well-developed
financial institutions.
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On the empirical side, there have been different approaches to investigate the relationship
between financial depth and economic growth. A number of researchers have discussed the
direction of causality between financial development and economic growth. The main
question is, does economic growth arise as a consequence of a higher financial development,
or vice versa? The existing studies generally provide conflicting views of this relationship.
King and Levine (1993), Filer et al. (1999), Rousseau and Wachtel (2000), Christopoulos and
Tsionas (2004), among others, provided an empirical evidence of a unidirectional causality
from financial depth to growth. However, other works like those of Agbetsiafa (2003),
Waqabaca (2004) and Odhiambo (2004) found that economic growth does indeed lead to
financial development. Studies of Jung (1986), Apergis et al. (2007) and Fowowe (2010), for
example, revealed the existence of a bidirectional relationship between finance and growth.
According to Islamic banks, they provide the same contributions to the financial system
and to the economy as the conventional banks. By the incorporation of ethical and moral
values in their modes of financing, Islamic banks motivate Muslim people to mobilize funds
and provide external resources to venture capital. Through the mechanism of profit-loss
sharing, their effect on economic development should potentially be more important. The
Islamic financial institution offers capital lending to the process of production and, by its
instruments, aims to contribute to companies’ capital. The allocation of the financial
resources according to the requirements of production is likely to be more efficient than the
allocation according to pure lending.
Siddiqi (1999) argued that the risk-sharing aspect incentivizes Islamic banks to be more
prudent in their decisions of lending and, consequently, allocate liquidity more optimally
than conventional banks. Therefore, theoretically it is expected that Islamic financing impact
on the economic development will be more important.
In the same line, it seems that corporate governance function is well-performed by Islamic
banks, as they benefit from the risk reduction of information asymmetry by sitting on the
firms’ board of directors. Consequently, they could influence corporate governance and are
likely to be able to control the performance of the firms financed. Thus, these modes of
financing are likely to be more efficient in monitoring by reducing risks of adverse selection
and moral hazard, which helps Islamic banks allocate resources more efficiently. It is
expected that their impact on economic development will be significant.
High-return projects tend to be riskier than low-return projects. Thus, financial markets
that facilitate risk diversification tend to move investors toward high-return projects
(Obstfeld, 1994). In turn, the absence of financial intermediaries that enhance corporate
governance may impede the mobilization of savings and prevent the capital from flowing to
high-return investments (Stiglitz and Weiss, 1983). Bencivenga and Smith (1993) indicated
Figure 1.
Financial sector and
economic growth:
transmission channels
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