Does Islamic Banking Matter for Economic Growth in

Bangladesh?

Muhamad Abduh1
Nazreen T. Chowdhury 2

Abstract
Islamic banking started three decades ago in Bangladesh and was expected to have a
significant relationship and contribution towards the economic growth of the country. This
study aims to investigate the long run and dynamic relationship between Islamic banking
development and economic growth in the case of Bangladesh. The quarterly time-series data
of economic growth, total financing and total deposit of Islamic banking from Q1:2004 to
Q2:2011 are used in this study. Using cointegration and Granger’s causality method, Islamic
bank financing is found to have a positive and significant relationship with economic growth
both in the long and short run. It implies that the development of Islamic banking is one of the
policies, which should be considered by the government to improve their income.

Keywords: Islamic banking, economic growth, cointegration, Granger causality, Bangladesh

1. Introduction
Islamic banking in Bangladesh is started in 1983 when the first Islamic bank in South
Asia, Islami Bank Bangladesh Limited (IBBL), was established. IBBL is a public
limited company with limited liability under the companies Act, 1913; it is a joint
venture multinational bank with sixty-four percent of equity being contributed by the
foreign sources.
To date, the development of Islamic banking industry in Bangladesh is quite
promising. For the case of IBBL, total deposit is increasing from Tk. 70,552.65
million in 2003 to Tk. 244,292.14 million in 2009 due to the increase in the number
of deposit account holders from 1,994,266 in 2003 to 4,361,896 in 2008 but slightly
decrease to 4,272,123 in 2009. Total income is also increasing from Tk. 6,710.44
million in 2003 to Tk. 25,403.86 million in 2009 and total investment goes up from
Tk. 62,755.90 million in 2003 to Tk. 255,272.41 million in 2009 and the number of

1
IIUM Institute of Islamic Banking and Finance (IIiBF), International Islamic University
Malaysia. Corresponding author email: abduh.iium@gmail.com
2
Postgraduate student at Department of Finance, Kulliyah of Economics and Management
Sciences, International Islamic University Malaysia.
 Does Islamic Banking Matter for Economic Growth in Bangladesh? 105

the shareholders rise to 52,164 in 2009 from 14,196 in 2003. Moreover, numbers of
employees increase from 4673 in 2003 to 9,588 in 2009 and the number of branches
also increase from 141 in 2003 to 231 in 2009 (Table 1).

Table 1. Selected development indicators of IBBL

Year 2003 2004 2007 2008 2009
Total
88,452.1 166,812.7 200,725.0 244,292.1
1. Deposits 70,552.65
8 8 0 4
(mill. Taka)
Total
83,893.6 174,365.5 198,763.0 255,272.4
2. Investments 62,755.90
3 5 0 1
(mill. Taka)
Total Income
3. 6,710.44 8,262.73 17,699.51 23,454.00 25,403.86
(mill. Taka)
No. of deposit
2,291,26
4. account 1,994,266 3,802,709 4,361,896 4,272,123
9
holder
Number of
5. 14,196 15,892 26,488 33,686 52,164
Shareholders
Number of
6. 4,673 5,306 8,426 9,397 9,588
Employees
Number of
7. 141 151 186 196 231
Branches
Source: Various issues of IBBL Annual Report.

Meanwhile, the performance of Al-Arafah Islami Bank Limited (ALBI), second

largest Islamic bank in Bangladesh, is also impressing. Total deposits increase from
Tk. 10,108.28 million in 2004 to Tk. 29,690.12 million in 2008 whilst total income
increases more than three times from Tk. 1,120.85 million in 2004 to Tk. 4,387.26
million in 2008. Furthermore, total investment increase from Tk. 8,150.16 million in
2004 to Tk. 29,723.79 million in 2008 and numbers of shareholders become double
from 5,379 in 2004 to 10,664 in 2008. The numbers of employees also increase as the
branches grow more (Table 2). Overall, Ahmed, et.al (2006) and Khan et.al (2007)
say that Bangladesh Islamic banks have better performance in various financial
measures than the conventional banks.
106 Journal of Islamic Economics, Banking and Finance, Vol. 8 No. 3, July - Sep 2012

Table 2. Selected development indicators of ALBI

Year 2004 2005 2007 2008
Total Deposits
1. 10,108.28 11,643.66 23,009.13 29,690.12
(mill. Taka)
Total Investments
2. 8,150.16 11,474.41 22,906.37 29,723.79
(mill. Taka)
Total Income
3. 1,120.85 1,452.68 2,955.61 4,387.26
(mill. Taka)
No. of deposit
4. - - - -
account holder
Number of
5. 5,379 5,402 12,013 10,664
Shareholders
Number of
6. 803 771 1,033 1,080
Employees
7. Number of Branches 40 41 46 50
Source: Various issues of ALBI Annual Report.

However, it is well-known that the objectives of the establishment of Islamic banks

are not merely company’s profit-oriented goals but also to create welfare in the
society and eventually to improve the economic growth of the country. Islamic banks
should not replicate the practice and goals of conventional banks, so they can play a
more significant role than conventional banks in improving the economic
performance of the country.
Unfortunately, after three decades of the establishment of Islamic banking in
Bangladesh, researches conducted within the framework of Islamic banking in
Bangladesh are lacking this issue and focused more on the development,
performance, and efficiency of Islamic banks. Therefore, this study aims to
empirically investigate the long run and dynamic relationship between the
development of Islamic banking in Bangladesh and their economic growth.

2. Finance – Growth Nexus

The nexus between financial development and economic growth has received great
attention from economists in the literature of development economics. From the many
research works carried out in this field, there are at least three types of nexus between
 Does Islamic Banking Matter for Economic Growth in Bangladesh? 107

financial development and economic growth that have been found i.e. supply-leading,
demand-following, and bi-directional causal relationships.
Supply-leading relationship is “the creation of financial institutions and instruments
in advance of demand for them in an effort to stimulate economic growth. This
strategy seeks to make allocation of capital more efficient and to provide incentives
for growth through the financial system” [Patrick, 1966: 175]. King and Levine
(1993) for instance, study this issue using data from 80 countries over the 1960-1989
periods. They have constructed four indicators of the level of financial sector
developments, which is regressed with the real GDP per capita and its sources. First
is “financial depth” which equals the ratio of liquid liabilities of the financial system
to GDP. Second is the ratio of deposit money bank domestic assets to deposit money
bank deposit assets plus central bank domestic assets to measure the relative
importance of specific financial institutions. The third and fourth financial
development indicators are designed to measure domestic asset distribution. The
proportion of credit allocated to private enterprises by the financial system and the
ratio of claims on the non-financial private sector to GDP are the third and fourth
indicators respectively. Their conclusion is consistent with Schumpeter’s view of
supply-leading theory that the financial development promotes economic growth.
This conclusion is also supported by the works of many researches such as Gregorio
and Guidotti (1995) and Calderón and Liu (2002).
Demand-following relationship, on the other hand, appears as a consequence of the
development of the real sector. This implies a continuous widening of markets and a
growing product differentiation which makes necessary more efficient risk
diversifications as well as better control of transaction cost [Hermes and Lensink,
1996: 17]. Finally, bi-directional causal relationship shows interdependency between
financial development and economic growth. Demetriades and Hussein (1996), for
instance, study 16 countries from all around the world which has the following
criteria; the country (i) must not be highly developed in 1960, (ii) has at least 27
continuous annual observations on the variables of interest and (iii) its population
must exceed 1 million in 1990. In spite of the rather technical nature of their criteria,
the data set contains countries with rich experiences in relation to both economic and
financial development. All of these countries, however, displayed some evidence of
reverse causation so that the relationship between financial development and growth
appears to be bi-directional. Again, Deidda and Fattouh (2002) and Rioja and Valev
(2002) posit that there is no significant relationship between financial depth and
economic growth in countries with low income per capita. The significant
relationship only appears in the high income countries.
108 Journal of Islamic Economics, Banking and Finance, Vol. 8 No. 3, July - Sep 2012

With regard to the causal relationship between Islamic banking development and
economic growth, Abduh and Omar (2012), Furqani and Mulyany (2009) and Majid
and Kassim (2010) are among the limited articles in this area. Abduh and Omar
(2012) identifies that the relationship is bi-directional. Therefore, the government
policies in supporting the development of Islamic finance in Indonesia are strongly
needed in order to support the economic development. However, using not-so-
different time span of quarterly data, findings from Furqani and Mulyany (2009) and
Majid and Kassim (2010) are different in terms of the direction of the relationship.
Furqani and Mulyany (2009), on the one hand, posit that the relationship between
Islamic financial development and economic growth is following the view of
“demand-following” which means that growth in real sector economy stimulates
Islamic banking institutions to change and develop. On the contrary, finding from
Majid and Kassim (2010) is in favor of the supply-leading view.

3. Data and Methodology

3.1. Data
The quarterly time series data from Q1:2004 to Q2:2011 of the total deposits (TD)
and financing (TF) of Islamic banking and economic growth (GDP) are used in this
study. The choice of the period is determined by the availability of data. The data are
collected from the world development indicators (WDI) of the World Bank, the
handbook of statistics on Bangladesh economy and Bangladesh Bank, and the
International financial statistics (IFS) of International Monetary Funds (IMF).
To study the relationship between the development of Islamic banking and the
economic growth of Bangladesh, the following models are derived:
lngdp = α +α +υ (1)
= α + α lngdp + υ (2)
lngdp = α + α lntdib + υ (3)
lntdib = α + α lngdp + υ (4)

Where:
lngdp : natural logarithm of real gdp
lntfib : natural logarithm of Islamic banks’ total financing
lntdib : natural logarithm of Islamic banks’ total deposits,
α's : coefficients ,
υ : disturbance term.
 Does Islamic Banking Matter for Economic Growth in Bangladesh? 109

3.2. Stationary Test

A unit root is tested with Augmented Dickey-Fuller (ADF) and Phillip-Perron (PP)
test. Do the variables observed have a tendency to return to the long-term trend
following a shock or the variables follow a random walk? If the variables follow a
random walk after a temporary or permanent shock, the regression between variables
is spurious. Hence, the OLS will not produce consistent parameter estimates.
All series should be stationary at the same level. ADF test is can be determined as in
Equation (5).

Yt   1   2 t  Yt 1   i i Yt 1   t

m

(5)
The hypothesis tested:
H0: δ = 0 (contains a unit root, the data are not stationary)
H1: δ < 0 (does not contains a unit root, the data are stationary)

Meanwhile, PP test can be determined as in Equation (6).

Yt  0  1t  Yt 1  vt (6)

The hypothesis tested:
H0: δ = 0 (contains a unit root, the data are not stationary)
H1: δ < 0 (does not contains a unit root, the data are stationary)

3.3. Cointegration Test

Cointegration means that even though the variables are not stationary individually,
the linear combination between two or more variables may be stationary. To test
cointegration, Johansen cointegration test is used.
Components in vector Yt is said to be cointegrated at d,b degree, presented by CI (d,b)
if:
(i) All components of Yt is I(d)
(ii) There is a non-zero vector β = (β1, β2, …, βn) so that the linear combination
of βYt = β1Y1t + β2Y2t + … + βnYnt will be cointegrated at (d – b) degree
where b>0. Vector β is the cointegration vector. In the case of b=d=1, Yt is
I(1) and their linear combination is I(0).
110 Journal of Islamic Economics, Banking and Finance, Vol. 8 No. 3, July - Sep 2012

Johansen (1991) and Johansen and Juselius (1990) produce the maximum likelihood
approach using the VAR model to estimate the cointegration relationship amongst
components in vector k variable Yt. Consider VAR model for yt:

A( L) xi   t (7)
The parameter can be presented in the form of Vector Autoregressive Error
Correction Mechanism:
p 1
Yt    i Yt i   Yt  p   t (8)
i 1

Where vector β = (-1, β2, …, βn) that contain r cointegration vectors, and speed of
adjustment parameter is given as α = (α1, α2, …, αn) when rank β=r<k, k is the
number of endogenous variables. If the number of cointegration relations is known,
hypothesis testing on α and β can be performed. Lag length specification for the
model can be determined by VAR equation using the AIC and SC criteria.

4. Results and Discussion

4.1. Stationary Test
This study utilizes Augmented Dickey-Fuller (ADF) and Phillips Perron (PP) tests to
identify the variables’ order of integration. Table 3 reports the result of those tests. It
can be seen that based on ADF and PP unit root test, lngdp, lntfib and lntdibcontain
unit root. It is therefore can be concluded that all variables are stationary at I(1).
Table 3. Stationary Test
ADF Phillip-Perron
Variable
Level 1st Difference Level 1st Difference
lngdp -0.752 -6.148*** -0.598 -6.156***
lntfib -1.722 -4.238*** -1.307 -8.142***
lntdib -0.193 -5.383*** -1.099 -5.414***
Note: * Significant at 10% alpha; ** Significant at 5% alpha; *** Significant at 1% alpha.

4.2. Cointegration and Long Run Equation

Having concluded that each of the series is stationary at first differenced, we continue
to examine whether there exist long run equilibrium between deposit and its
determinants. Table 4 presents the result from the Johansen-Juselius cointegration
test. We employ two criteria, which are commonly used i.e. AIC and SC in order to
determine the vector autoregressive lag order, and the optimal lag length is 2 for both
relationships tested.
 Does Islamic Banking Matter for Economic Growth in Bangladesh? 111

For a small sample analysis, Reinsel and Ahn (1992) suggested an adjustment to the
estimated trace statistics. The degree-of-freedom correction suggested by Reinsel and
Ahn (1992) is to multiply the computed trace statistic by (T-pk)/T, where T is the
sample size, p is the number of variables, and k is the lag length of the estimated
VAR system. In the analysis that follows, we relied on the Reinsel and Ahn
suggestion to check for the significance and the robustness of the cointegration tests.

Table 4. Cointegration Test

Hypothesized Trace 5% Critical Reinsel-Ahn
Equation
No of CE(s) Statistic Values Adjustment
lngdp - lntfib r≤0 23.795*** 15.495 20.622***
r≤1 3.518 3.842 3.329
lngdp - lntdib r≤0 15.199 15.494 13.172
r≤1 3.853** 3.841 3.339
Note: * Significant at 10% alpha; ** Significant at 5% alpha; *** Significant at 1% alpha.

For lngdp-lntfib relationship, one cointegrating vector is shown by the fact that
Reinsel-Ahn adjustment trace statistic value is 20.622 and it is greater than 5%
critical value of 15.495. It means that economic growth and Islamic bank financing
found to be cointegrated or there is a long run equilibrium governing the relationship
among the variables. However, there is no evidence of cointegration between lngdp
and lntdib after the Reinsel-Ahn adjustment towards its computed trace statistic.

ect = lngdp – 0.557895lntfib – 1.446171 (9)

(-30.5826)

ect = lntfib – 1.792452lngdp + 2.592192 (10)

(-30.5826)
In order to see the direction of the relationship between lngdp and lntfib, Granger
causality and long run equation analysis are executed. Equation 9 and 10 above are
depicting the long run equation between lngdp and lntfib. It is shown in the equation
9 that total financing of Islamic banking has a positive relationship with Bangladesh
economic growth in the long run. Similarly, economic growth has also positive
relationship with total financing of Islamic banking. This suggests that the
development in Islamic banking and finance stimulates growth and, at the same time,
the support received from the government in the expansion of the real sector can
112 Journal of Islamic Economics, Banking and Finance, Vol. 8 No. 3, July - Sep 2012

significantly influence the development of Islamic banking in Bangladesh. These bi-

directional relationships are also depicted by the Granger causality test below.
Table 5. VEC Granger Causality Test
Dependent Variable
Independent Variable
D(lngdp) D(lntfib)
D(lngdp) - 10.75136***
D(lntfib) 6.450388** -
Note: Figures in the cell are chi-squared value of VEC Granger causality test.
* Significant at 10% alpha; ** Significant at 5% alpha; *** Significant at 1% alpha.

This finding implies that developing Islamic banking and finance industry is one of
the relevant policy options to promote economic growth in Bangladesh. In this
context, continuously improving Islamic financial infrastructure and regulation in
Bangladesh may provide sustainable economic growth in the long-run.

5. Conclusion
This paper is aimed at investigating the role Islamic banking upon economic growth,
particularly in Bangladesh. Using cointegration methodology, the results show that
Islamic bank financing has shared long run positive relationship with economic
growth. The relationship is neither supply leading nor demand following. It appears
to be bi-directional relationship between Islamic bank deepening and economic
growth. It implies that the development of Islamic banking will also support the goal
of the country in improving their income.

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