The Islamic Banking and Economic Growth Nexus: A Panel VAR Analysis for Organization of Islamic Cooperation (OIC) Countries

In this paper, we investigate the impact of Islamic banking variables on economic growth in a panel setting for 14 member countries of the Organization of Islamic Countries during 1999-2011 period. We examine the short-run effects as well as long-run effects by employing the Panel VAR method. We find a positive and significant relationship between Islamic finance and economic growth. This relationship is robust with regard to several macroeconomic control variables such as capital stock, unemployment, inflation, and government expenditure. We show that an increase in the share of Islamic deposits, assets, and loans in total banking instruments results in an increase in economic growth. The results also show that in the long run, economic growth responds positively to shocks in Islamic instruments, namely Islamic deposits, investments, and size. Shocks in Islamic banking contribute to more than 3% of the forecast error in economic growth in the next 10 year period.