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Go Back       IAR Journal of Business Management | IAR J Bus Mng, 2020; 1(4): | Volume:1 Issue:4 ( Nov. 25, 2020 ) : 272-279.
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DOI : 10.47310/iarjbm.2020.v01i04.011       Download PDF       HTML       XML

The Role of Islamic Banking Industry in Indonesia's Economic Growth

Article History

Received: 25.10.2020; Revision: 04. 11.2020; Accepted: 19. 11.2020; Published: 21. 11.2020

Author Details

Cut Devi Rianti1, Raja Masbar2 and Suriani3

Authors Affiliations

1Master Student in Economics, Faculty of Economics and Business, Universitas Syiah Kuala, Indonesia

2Professor, Faculty of Economics and Business, Universitas Syiah Kuala, Indonesia

3Associate Professor, Faculty of Economics and Business, Universitas Syiah Kuala, Indonesia

Abstract: This study investigates the role of Islamic banks in the Indonesian economy over the period from 2009 to 2019. Based on the error correction model, the study documented that Islamic banking institutions have significantly contributed towards the promotion of the Indonesian economy in the long-run, but their contribution in the short-run is found to be insignificant. The study suggests that to promote national economic growth further; the government should design supportive policies to encourage Islamic banks to provide more investment financing distribution to the real sector. Islamic banks are expected to cooperate with the monetary authorities to improve their performances so that they can compete with conventional banks and consequently drive the entire sector of the econom.

Keywords: Islamic banks; Economic growth; Indonesian economy.


Indonesia is the most prominent Muslim populous country with a population of 269.6 million that experiences a reasonably good economic activity. According to Yusof and Bahlous (2013), economic growth is a condition of the development of the Gross Domestic Product (GDP), which reflects the change in output per capita and the increase in people's living standards. The economy is said to experience growth if the production of goods and services increases from the previous year. GDP is often used by economists to measure a country's economic growth. In addition, GDP is also often used as the key indicator for the economic performance the government intends to achieve by designing various economic policies (Bank Indonesia, 2015). Over the 2010-2019 period, the Central Statistics Agency (2020) of the Republic of Indonesia reported that Indonesia's economic growth experienced a slowing trend. The rate of economic growth in 2019 has decreased by 5.02% from the year 2018.

An increase in economic growth shows the improvement of the economy of the country. If it continuously grows over the more extended period, thus the country experiences an economic development (Encinas-Ferrer and Villegas-Zermeño, 2015). Conversely, if an economy fails to develop properly, the economic problems arise, such as unemployment, poverty, low level of living standards, and so on.

The economy of a country is built on two sectors, namely the real sector and the monetary sector. The real sector is an economic sector that is concentrated in the manufacturing and service sectors. Meanwhile, the monetary sector is a policy made by the central bank to influence the macro situation through the money market (Majid, 2007; Kassim and Majid, 2009; Majid and Hasin, 2014; Dyatama and Yuliadi, 2015). Based on data from the United Nations Conference on Trade and Development (UNCTAD), GDP can be classified into several sectors, namely agriculture, industry and services. Whereas, the financial sector is part of the service sector.

The financial sector plays an essential role in encouraging a country's economic growth, namely as a driver of growth in the real sector. This can be seen from the ability of the financial sector to mobilize savings. The stability of the financial services sector as an intermediary institution continues to show modest growth over the last decade in Indonesia. This is in line with positive developments in economic indicators and the real sector (Financial Services Authority, 2019).

Since its establishment in 1992, the Islamic banking industry in Indonesia shows its steady growth. The third-party funds (TPF) collection and total financing of Islamic banks continue to increase over the 2013-2019 period. TPF collection continued to grow from IDR184 billion (2013) to IDR218 billion (2014), IDR231 billion (2015), IDR279 billion (2016), IDR335 billion (2017), IDR375 billion (2018), and IDR 416 billion (2019), respectively. The average total TPF of Islamic banking from 2013-2019 was IDR291 billion. Meanwhile, in view of the total financing, it has increased from IDR184 billion (2013) to IDR199 billion (2014), IDR213 billion (2015), IDR235 billion (2016), IDR272 billion (2017), IDR306 billion (2018), and IDR335 billion (2019), respectively, with an average of IDR249 billion.

Furthermore, Islamic banking financing can be divided into two types based on the nature of its use, namely productive financing, in the form of working capital and investment financing, and consumptive financing, namely consumption financing (Antonio, 2001). Over the 2015-2019 period, working capital financing of Islamic banks has continued to experience a moderately increase. In 2015, the total working capital financing was IDR63.6 billion and increased to IDR87.3 billion (2016), IDR99.8 billion (2017), IDR105 billion (2018), and IDR110,586 billion (2019), respectively, showing an average increased by IDR378 billion (Financial Services Authority, 2019).

Similarly, the accumulation of Islamic bank productive financing for a similar period has also continued to increase quite well. The total funding has increased from IDR40,239 billion in 2015 to IDR60,042 billion (2016), IDR66,848 billion (2017), IDR74,730 billion (2018), and IDR86,972 billion (2019), indicating an average increase by IDR260.2 billion (Financial Services Authority, 2019).

The increase in the use of Islamic financial products and instruments encourages the development of the real sector (El-Ayyubi et al., 2018). Islamic banking can make an excellent contribution to economic growth (Imam and Kpodar, 2015). By combining ethical and moral values in their financing distribution, the Islamic banking institution can motivate Muslims to mobilize funds and also provide external resources for venture capital, which in turn contribute to economic growth.

Furthermore, Anass et al., (2017) state that Islamic banking institution can aim to invest in large projects that contribute to increasing the growth of the economic sector. The existence of a close relationship between Islamic banking and the real sector has triggered the development of Islamic banking which leads to economic growth, so it has received significant attention from economists (Abduh and Chowdhury, 2012).

Based on the above background, this study intends to explore the contribution of Islamic banking financing for working capital and investment on Indonesia’s economic growth both in short- and long-run. The findings of this study are hoped to shed some lights for the policy-makers in designing a proper strategy to enhance the contribution of Islamic banking presence to the national economy of Indonesia.

The rest of the study is structured in the following sequences. Section 2 reviews the relevant theories and existing literature. Section 3 provides the data and research framework, followed by the discussion of the findings in Section 4. Finally, Section 5 concludes the paper.


Economic growth

The economic theory put forward by Schumpeter in 1908 shows that economic growth will not continue to increase over time. It sometimes declines, steady, and increases. Its volatile nature is simply due to the activities of entrepreneurs in innovating or integrating into activities that produce goods and services (Lebdaoui and Wild, 2016). National economic growth shows the ability of the people to get additional income at a specific time, namely by increasing work productivity and additional capital. To support economic growth, financial institutions are needed to facilitate the public's need for financial assets. Having sufficient financial assets it helps the community to support their businesses that create steady economic growth (Bidabad and Allahyarifard, 2008).

Economic growth is often measured by changes in Gross Domestic Products (GDP) (Mankiw, 2007). GDP is the leading indicator of economic performance, measuring the output of goods and services produced by a country. GDP can be classified into two, first total GDP, which measures the total production of goods and services produced by a state, and second, GDP per capita, namely the output of goods and services produced per one population of a country.

Furthermore, GDP also classified into the nominal GDP and real GDP. Nominal GDP measures the value of goods and services according to the price prevailing in that period. It is not a very precise measure of actual productivity. An increase in nominal GDP can be caused by non-increase in productivity, but rather an increase in the prices of goods. Meanwhile, real GDP measures the value of goods and services based on constant prices. This measure is more appropriate to show the productivity of a country because prices are calculated at a steady rate.

Solow Growth Model

One theory regarding economic growth is the Solow growth model. The model shows that the amount of output per worker is a function of the amount of capital per worker. The production function shows how the quantity of capital per worker determines the amount of output per worker, Y = f(K). The slope of the production function explains how much additional output a worker produces when obtaining one additional unit of capital. This model further shows how saving (capital stock), population growth and technology affect the economy's output level and its change over time (Mankiw, 2007).

The capital stock is an essential determinant of output because the capital stock can change over time, and this change can lead to economic growth. Depreciation and investment are factors that affect the capital stock. Investment refers to spending to increase the capital stock, whereas depreciation is an expense that causes the capital stock to decrease. The Solow model suggests that sustainable growth in income per worker must come from technological advances, assuming technological progress as an endogenous variable. Economic growth is connected to the financial sector, such as the banking industry. The presence of Islamic banking institution in Indonesia in the early 1990s is believed to play a significant role in the Indonesian economy.

Islamic Banking Institution

Banks are basically entities that collect funds from the public in the form of financing and carry out the function of financial intermediation. Unlike the conventional banks, the Islamic banks carry out their business activities based on Islamic law principles, which are free from the elements of interest (riba), uncertainties (gharar), and gambling (maysir). Islamic banking also functions as an intermediary for channelling funds to promote activities in the economy. Hence, the presence of Islamic banks is expected to have a positive impact on economic growth. Islamic banks are also believed to bring benefits to the financial system and the real sector (Yusof and Bahlous, 2013; Majid and Kassim, 2015).

According to Yüksel and Canöz (2017), there are several reasons for the presence of the Islamic banking system. First, the religious motive is crucial for this situation. Since interest is strictly prohibited in Islam, thus Muslims need a banking system that operated based on Islamic tenets. Second, social reason also plays a vital role in the Islamic banking system. The interest-based banking system is claimed to cause income inequality among people; thus, it is a need to have Islamic banks within the biggest Muslim populous country of Indonesia.

In their study, Gheeraert and Weill (2015) find that Islamic finance supports macroeconomic efficiency. This study also supports a non-linear relationship between the efficiency and development of the Islamic financial sector, measured by the number of their financing and deposits. Islamic banking financing is the provision of funds or claims that have been agreed upon based on an agreement between the Islamic banks and other parties, which requires the financed party to repay the funds after a certain period in exchange for a fee (ujrah), without compensation, or profit-loss sharing.

Antonio (2001) divides Islamic banking financing into productive and consumptive financing. Productive financing is offered to meet production needs in a broad sense, namely to increase business both in production, trade and investment businesses. According to their needs, productive financing can be further divided into working capital and investment financing. Working capital financing is meant to finance the need for increased production, both quantitatively, namely the amount of output, as well as qualitatively, namely increasing the quality or quality of products and for trading purposes or improving the utility of place of an item. Meanwhile, investment financing is meant to meet the needs of capital goods and facilities that are closely related to it. Investment is a placement in a number of funds with the hope of obtaining future benefits. In general, investment is divided into two, namely investment in financial assets made in the money market and real asset investment, namely in the form of purchasing a productive asset, to invest in the capital market requires sufficient knowledge (Caporale and Helmi, 2018).

On the other hand, consumptive financing is provided to meet consumption needs. In general, based on its contracts, Islamic banking financing can be divided into profit-loss sharing, leasing, and financing and borrowing. Profit-loss sharing financing comprises mudharabah and musharakah contracts (Sabrina and Majid, 2020). Mudharabah is a fund financing contract from the owner of the fund to the fund manager to carry out certain business activities following the Islamic principles, with the sharing of business loss and profits between the two parties based on a previously agreed ratio. Meanwhile, musharakah is a financing contract of two or more fund owners to run a particular business following Islamic principles by sharing the profits between the two parties based on an agreed ratio. In contrast, the sharing of losses is based on the proportion of the respective capital.

Furthermore, the leasing transactions of Islamic banking consists of ijarah contract, a lease and purchase transaction with an ijarah muntahiya bittamlik contract. Ijarah is a financing agreement in the form of a lease transaction for goods and services between the owner of the object for lease, including ownership of use rights over the object of lease and the lessee to get a reward for the object for rent. Sale and purchase transactions in the form of murabahah, salam and istishna receivables. Murabahah is a financing contract in the form of a sale and purchase transaction of an item at the cost of the goods plus the margin agreed upon by the parties, where the seller informs the buyer in advance of the acquisition price. Salam is a financing contract in the form of buying and selling of goods by ordering with certain conditions and in a full advance cash payment. Meanwhile, istishna is a financing contract in the form of a sale and purchase transaction in the form of an order for the manufacture of goods with specific criteria and conditions agreed upon with payment according to the agreement.

Finally, lending and borrowing transactions of Islamic banking is in the form of a qardh contract. This contract is a financing contract in the form of lending and borrowing transactions without compensation with the obligation of the borrower to return the loan principal at once or in instalments within a certain period.

As for the Islamic banking deposits (or in the Indonesian term called as the third party funds, TPF), El-Ayyubi et al., (2018) define it as an unrestricted savings funds entrusted by banking customers in the forms of demand deposits, savings, time deposits or others. These funds include giro, time deposit, and savings. Giro is demand deposits that can be used as a means of payment and can be withdrawn at any time by check, or by way of overbooking. Current accounts are an uncertain source of funds for banks because they can be withdrawn at any time. Meanwhile, time deposits are deposits that can only be withdrawn at a particular time according to the agreement between the depositor and the bank. The characteristic of a time deposit is a fixed withdrawal. Therefore, it is often called a fixed deposit. Finally, savings can only be made according to certain conditions agreed upon, but cannot be withdrawn by check or an equivalent instrument. Banking customers who wish to take advantage of this deposit facility, apart from having a checking account, must open a savings account at the same bank.

As an intermediation financial institution, Islamic banks with a large number of assets can encourage technological innovation by channelling their funds into the productive economic sector so that it will promote economic growth. In short, the number of banking assets has a positive effect on economic growth (Lebdaoui and Wild, 2016).

Previous Related Studies

The Islamic finance sector is needed to promote economic activities that are in accordance with Islamic principles, to make a better contribution to the future economy. The development of Islamic finance leads to better progress in real economic activity, which in turn stimulates the development of Islamic finance (Zarrouk et al., 2017). Caporale and Helmi (2018) investigate the relationship between Islamic banking financing and GDP by comparing seven developing countries, the first without Islamic banks and the second with dual banking systems, including Islamic and conventional banks. Using time-series and panel analyses to test both short- and long-term causal relationships, the study document the significant different contribution of Islamic banks to the economic growth between the investigated countries.

In the long-run, the development of Islamic finance has a positive and significant correlation with economic growth and capital accumulation (Abduh and Omar, 2012). In this regard, domestic funds provided by the Islamic banking sector contribute to economic growth. In other words, Islamic banking has proven to be useful as a financial intermediary that facilitates the transmission of funds from surplus households to deficit households.

Furthermore, El-Ayyubi et al., (2018) find a significant influence of Islamic banking and economic growth in Indonesia. Islamic banking financing has contributed to economic growth but not Islamic banking deposits. Similarly, Furqani and Mulyany (2009), Majid and Kassim (2015) and Hakim and Uddin (2016) document a significant contribution of Islamic finance to economic growth in the long-run Malaysian economy. This shows that developing the Islamic banking and finance industry is one of the appropriate policy options to encourage economic development in Malaysia. In this context, continuing to provide a conducive environment to long-term growth is very helpful in supporting economic growth in the country.

Meanwhile, Abduh and Chowdhury (2012) analyzed the relationship between Islamic banking and economic growth in Bangladesh. Using cointegration and Granger causality test, the study finds a significant positive relationship between Islamic banking in Bangladesh and economic growth in the short- and long-term. Finally, Thierry et al., (2016) document a one-way causal relationship between bank credit and economic development in Cameroon. In short, previous studies demonstrate evidence of the critical role of Islamic banks into in promoting economic growth in various countries.


This study explores both short- and long-run relationships between Islamic banking financing for working capital and investment and economic growth for the case of Indonesia. A battery of time series analyses comprises tests of unit root, cointegration, and Error Correction Model (ECM) are performed. The ECM is an econometric model that can measure how long it takes for a short-term disequilibrium to be corrected into long-term balance. This model is used when there is cointegration in a group of variables that is non-stationary. Economically, the existence of cointegration shows that there is a long-term equilibrium relationship that can be said to be in a long-run equilibrium state. However, the presence of cointegration does not necessarily guarantee short term equilibrium.

Before estimating the ECM model, it is necessary to conduct a stationary test on each variable used in the model. If the results of the test show that all variables in the model are stationary, the cointegration is tested in the next step of the analysis. The cointegration test serves to determine the long-term stability or balance between the variables used in the model.

Unit Root Test

The purpose of conducting unit root test is to ensure that there is no change over time which can cause the estimation results to be robust (Baltagi, 2005). This test is used to check whether the observed data is stationary or not. Variables that contain unit roots or are non-stationary produce meaningless inferences. This is indicated by a high R-square and t-statistics that appear significant and ultimately provide the wrong direction and lead to the use of inappropriate policies (Gujarati, 2006).

This study uses the Phillips-Perron (PP) test for performing the unit root test. If the data is non-stationary at the level, the test is further conducted at the first difference, and so on. If the absolute value of the PP statistic is greater than the critical value, then the data tested is said to be stationary. In contrary, if the absolute value of the PP statistic is smaller than the critical value, then the data is said to be non-stationary.

The PP test is measured with the following equation:


To test for the unit root, the null hypothesis of H0: δ = 0 (contains the unit root, data is non-stationarity) is tested against the alternate hypothesis of H1: δ < 0 (contains no unit root, data is stationarity)

Cointegration test

The cointegration test was first introduced by Engle and Granger and further developed by Johansen. The cointegration tests that are most commonly used comprise Johansen-Juselius, Engle-Granger, Augmented Engle-Granger, and Durbin-Watson cointegrating tests. The cointegration test is conducted based on the following equation:

= + + (2)

where ECOG is the economic growth, WRCF is the working capital financing provided by Islamic banks, INVF is the investment financing provided by Islamic banks, bi is the estimated regressors, t is the time period, and is the error term.

The next step is to estimate the autoregressive equation model from the residuals based on the following equations:

= (3)

= + i (4)

To test for cointegration, the null hypothesis of = I(1), meaning that there is no cointegration is tested against the alternate hypothesis of I(1), meaning that there is cointegration.

Error Correction Model (ECM)

The following ECM equation is estimated to explore both short- and long-run relationships between Islamic banking financing for working capital and investment and economic growth for the case of Indonesia.


where ECOG is the economic growth, WRCF is the working capital financing provided by the Islamic banks, INVF is the investment financing provided by the Islamic banks, βi is the estimated regressors, t is the time period, ECT is the error correction term, and μ is the residual term.


This study investigates the effects of working capital and investment financing by the Islamic banking industry on the economic growth of Indonesia over the period from January 2009 to December 2019. Economic growth is measured by the changes in the total real GDP of Indonesia, gathered from the Central Bureau of Statistics of the Republic of Indonesia. Meanwhile, working capital financing is measured by the total of Islamic banking financing provided to micro, small, and medium enterprises (MSMEs) and non-MSMEs to meet the needs for increased production in the IDR billion. Finally, investment financing is measured by the total Islamic banking financing provided for MSMEs and non-MSMEs in the IDR billion. These Islamic banking financing data are gathered from the Otoritas Jasa Keuangan (Financial Services Authority) Sharia Banking Statistics of the Republic of Indonesia.


All data for time series of the error correction modelling analysis are necessary to be in the stationary form. Thus, to ensure the data stationarity, the Phillips-Perron (PP) unit root test is performed.

Table 1. Findings of the Unit Root Test


Probability value



1st Different













Note: *** indicates significance at the 1% level.

Table 1 reports the results of the stationary test. As reported in the table, all data are non-stationarity at the level. After taking the first difference, all data are found becoming stationarity at the 1% level of significance.

Having identified all data are stationarity at the first difference, the next step of the cointegration test is conducted to determine the existence of a long-run relationship among the investigated variables. The cointegration test is a sufficient condition for the error correction model estimation. The test is used to view whether the estimated variable has a long-run, linear, and stable relationship. The cointegration test was estimated by forming the residuals obtained by regressing the independent variables on the dependent variable using the ordinary least square technique. If the residuals are stationary at the level and have a linear long-run relationship, thus the data are said to be cointegrated. The findings of the cointegration test are reported in Table 2.

Table 2. Findings of Cointegration Test






PP test statistic




Critical values:









Note: *** indicates significance at the 1% level.

As illustrated in Table 3, the data are found to be cointegrated at the 1% level of significance. This finding shows that each variable tends to move together towards long-run equilibrium. This further implies that to predict a movement of a variable in the estimated model, one could refer to another variable, as the variables having a long-run relationship. Since the data are cointegrated, thus the error correction model could be used appropriately to predict both short- and long-run relationships between Islamic banking financing and economic growth in Indonesia.

Table 3. Findings of the Long-Run Relationship

















= 0.8572; = 0.8572; F-Stat (Prob) = 0.0000

Note: *** indicates significance at the 1% level.

As reported in Table 3, investment financing (INVF) of Islamic banking is found to have a positive long-run relationship with the economic growth at the 1% significant level. In contrast, the working capital (WRCF) of Islamic banking is found to be insignificant. It can be concluded that in the long- term, the financing of Islamic banks provided for the Investment purposes has contributed to promoting economic growth in Indonesia. The reason is that when there is an increase in disbursed investment financing, it has an impact on the funding for businesses and consequently causes an increase in the real sector economy. An increase in the real sector economy means an increase in economic activity, which causes an increase in economic growth. This finding is supported by previous studies, such as Rama (2013), Abduh and Omar (2012), and Majid and Kassim (2015), who found a significant role of Islamic banking in the Indonesian economy.

Furthermore, the adjusted coefficient of determination of 0.8572 indicates that the changes in economic growth are explained 85.72% by changes in investment financing. In comparison, the remaining 14.28% is influenced by other variables not investigated in our analysis. This finding further suggests that to enhance the economic growth, thus the government should provide a conducive environment for the Islamic banking institutions to offer more financing for the investment purposes by giving tax incentives and other supportive regulations.

Table 4. Finding of the Error Correction Model





















= 0.1128; = 0.0917; F-stat (Prob) = 0.0017

Note: *** indicates significance at the 1% level.

Furthermore, Table 4 reports the finding of the error correction model. As shown in the table, the coefficient of error correction term (ECT) is found to negatively significance at the 1% level. This finding shows our estimated model is free from misspecification as its ECT is found to negatively significance. This coefficient measures the regressors’ response in each period that deviates from the equilibrium. It shows an imbalance correction coefficient in the form of an absolute value explains how fast it takes to get the equilibrium value. Thus, our finding indicates that the existence of short-run disequilibrium is adjusted towards a long-run equilibrium with the speed of adjustment of -0.1766 or about 5.66 months. This finding further confirmed our earlier finding that the presence of Islamic banks had promoted the economic growth of Indonesia.

The findings from Table 4 show that both Islamic financings for working capital and investment purposes have insignificant effect in short-run on economic growth, while the effect is only documented in the long-run. The insignificant short-run effect is simply due to the financing provided by the Islamic banks would not immediately contribute towards economic growth, as the funding takes time for the businesses to produce profits, thus contributing to the national economic development.

Overall, the study shows the crucial role of the Islamic banking industry in the Indonesian economy, as it has contributed towards long-run economic growth. To further promote economic growth, thus the government should support the presence of Islamic banks by providing supportive regulation, such as tax incentive so as the Islamic banks could be one of the essential financial pillars to boost national economic growth in the future.


This study investigated the contribution of Islamic banks to the promotion of economic growth in the Indonesian economy over the period from 2009 to 2019. Using the error correction model, the study documented that Islamic banking financing and economic growth has a long-run equilibrium. This finding signifies that the movement of the progress of the Islamic banking industry run in parallel with the progress of economic growth in the long-run. Besides, the study also found that financing provided by Islamic banks to investment purposes has a significant long-run effect on economic growth. In contrast, the funding for working capital is found to insignificant. This finding implies that investment financing channelled by Islamic banks has a positive effect on the Indonesian economy.

Based on the results of this study, it is suggested that to strengthen the presence of Islamic banks; the government is expected to issue supportive policies to promote economic growth by maintaining the stability of the distribution of financing by the Islamic banks. Islamic banks are expected to cooperate with the monetary authorities and improve their assets’ management (Majid et al., 2014), corporate governance, risk management (Maulidar and Majid, 2020), performances (Hamid et al., 2017), and efficiency (Omar et al., 2007; Ismail et al., 2013) so that they can compete with conventional banks. To increase economic growth, Islamic banks must be more active in increasing the proportion of financing in sectors that can drive the real economy.

To offer more comprehensive findings on the contribution of the Islamic banking industry to the economic growth, future studies are suggested to explore the contribution of Islamic banks to the stability of macroeconomic conditions. Comparing the contribution of Islamic banks worldwide to the global economy would also enrich the existing empirical findings.


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