Financial development, Islamic finance and economic growth: evidence of the UAE
, (Emirates College of Technology, Abu Dhabi, UAE and PS2D, Faculty of Economics Sciences and Management, University Tunis El Manar, Tunis, Tunisia)
Single Sentence Summary:
This paper shows a unidirectional causality from the development of the financial system to economic growth, however, Islamic financial institutions in the United Arab Emirates have benefited from sustainable economic growth.
Abstract
Purpose
Does Islamic finance affect economic growth? The empirical literature in this area seems to be in the 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 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.
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, 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.
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 that a well-functioning financial system improves corporate governance by economizing on monitoring costs, reduces credit rationing and consequently stimulates productivity, capital accumulation and growth. Čihák and Hesse (2008) proved that the Islamic financial system is less risky than the conventional system. By excluding the interest on the principal from its mechanism, Islamic banks prevent all speculative activities related to the interest rate expectations and thus reduce uncertainty.
Change in money flow will directly reflect on real activity by a change in the supply and demand of goods and services. The financing of Islamic banks through Musharakah and Mudarabah is related to the real economic sphere. The time value of money is maintained, and other rates through the mechanism of profit and loss sharing are used. These financing modes are likely to reduce risk and uncertainty, thereby helping Islamic banks to allocate resources more efficiently. While inflation and interest rates are the basic motivation for people to spend and circulate money in conventional economics, Islamic economy has other methods to motivate people to circulate money and stimulate real investment. People having the Nisab, who pay Zakat of 2.5 per cent from their wealth to poor people, are motivated to spend or invest money than to save it. The Prophet said that fund should be invested before it is eaten by Sadaqah. Thus, the received Zakat is also spent. Consequently, an increase in the demand increases the supply, and the prices are maintained at the same level but only the quantity produced increases. Real assets and money used only to exchange the resources facilitate the growth of the Islamic economic system without inflation.
The empirical studies on Islamic finance conducted have mainly assessed the performance and stability of Islamic financial institutions compared to conventional ones (Hasan and Dridi, 2010; Hanif et al., 2012; Arbi et al., 2014; Basov and Bhatti, 2014; and Mansor et al., 2015). There are few studies analyzing the relationship between Islamic finance and economic growth. Furqani and Mulyany (2009), for example, examined the dynamic interactions between Islamic banking and the economic growth of Malaysia by using the cointergration test and vector error correction model (VECM). They found that in the short run, only fixed investment caused the expansion of Islamic banks during 1997-1 through 2005-4. However in the long run, there is evidence of a bi-directional relationship between Islamic banks and fixed investment, and there is evidence to support that the increase in GDP causes development of Islamic banking and not vice versa. Abduh and Chowdhury (2012) analyzed 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 banks from Q1:2004 to Q2:2011 are used. Applying cointergration and Granger’s causality, the study confirms a positive and significant relationship between Islamic banks’ financing and economic growth in the long as well as in the 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.
Several critics were highlighted by Goaied and Sassi (2010). They argued that the empirical literature on the impact of Islamic finance on economic growth in Middle Eastern and North African (MENA) countries is still in its early stages. In addition, they indicated that a large number of empirical studies have used different types of econometric approaches and a variety of indicators. The results are often mixed and inconclusive. Thus, the issue still attracts both academia and policy-makers to advance the knowledge in this area.
With respect to the case of the UAE, studies that tried to investigate the multi-faceted relationship between financial development, Islamic finance and growth are very few. Mosesov and Sahawneh (2005) examined the finance-growth nexus in the UAE. Based on time series data (1973-2003), authors found no positive and/or significant evidence to suggest that financial development had influenced the economic growth. However, the UAE economy is dependent on the world oil market prices. Such dependence may influence financial development – economic growth nexus.
Also, Al-Malkawi et al. (2012) found that financial development and economic growth are consistently and negatively correlated. The results display a bidirectional causality between the two variables. These findings inform both the demand-following and the supply-leading hypotheses for the UAE.
In a recent study, Tabash and Dhankar (2014), using time series data from 1990 to 2010, revealed that there is a strong positive association between Islamic banks’ financing credited to private sector and the GDP, Gross fixed capital formation and foreign direct investment inflow (FDI). Their results indicate that a causal relationship happens only in one direction from Islamic banks’ financing to economic growth. Furthermore, the results show that Islamic banks’ financing has contributed to the increase of investment and the attraction of FDI in the long term and in a positive way in the UAE. However, a bi-directional relationship was noted between Islamic Banks’ financing and FDI.
3.Data and methodology
3.1Data
The present study examines the causal relationship between financial development and economic growth in the UAE using annual data from 1990 to 2012.
Three main sources are used: the World Bank’s World Development Indicators database, Islamic Banks and Financial Institutions Information (IBIS) database and Financial Development and Structure Dataset (2013) of Beck et al. (2000)
Different indicators will proxy different aspects of the financial system and economic development. In relation to the financial system, a number of variables are used which include: domestic credit to private sector by banks as a percentage of GDP; domestic credit provided by the financial sector as a percentage of GDP; and money and quasi-money as a percentage of GDP. King and Levine (1993) believe that the rate of liquidity is a reliable indicator of financial development. The two first indicators are used to assess the allocation of financial assets and likely are more linked to economic growth through the channel of financed investment. Total Islamic financial investment as a percentage of GDP is a proxy for Islamic financial development. It discloses the sum of total outstanding amount of all modes of finance (Murabaha, Mudarabah, Ijarah, Musharakah, Salam and Istisna), the investment portfolio, the prepaid expenses and other receivable; and real GDP is used as proxy for economic development.
The description and source of all variables of interest are presented in Table I.
3.2 Methodology
The methodology used to assess the relationship between financial development, Islamic finance and economic growth is divided in three steps. First, to assess the effect of the different dimensions included in the concept of financial development, the authors proposed a composite indicator determined with the non-parametric approach: data envelopment analysis (DEA). This approach uses linear programming tools and defined a best practice frontier that serves as a benchmark for estimating the performance of a given set of units. Financial sector performance is represented by the distance to the best practice frontier, and weights for partial indicators are endogenously calculated in such a way that the distance is minimized for every unit. More precisely, the authors present a variant of the DEA model: the radial model without inputs (Lovell and Pastor, 1999). This approach is supposed to be able to direct all the partial indicators toward their maximum values. It is a DEA model directed toward the outputs, and only one input is a dummy equal to the unit for all the studied decision making units (DMU)[1]. The purpose is to maximize the composite indicator given the constraint of the partial indicators availability[2]. The DEA model is thus the following:
Figure 2(d) confirms that the Islamic banking sector is developing rapidly alongside the conventional system. UAE is emerging as a serious player in the Islamic banking market. However, Figure 2(d) shows a decrease in Islamic investment in 2009. Islamic banks are exposed to risks similar to those of conventional banks where their activity has been affected by the downturn of the global crisis (Zarrouk, 2012). A revival of the economy was observed during 2012.
The UAE continually records a high economic growth rate in an environment with relative price stability. Growth was led mainly by strong tourism activity, the trade and transport sectors and a leaping in real estate activity. These developments reflect the country’s various policies, which contributed to a remarkable expansion of the non-hydrocarbon sector and are expected to bear strong growth going forward.
UAE has continued to reap benefits from its safety shelter status. Figure 3 shows a decrease of the real GDP during 2009-2010 with a defection of the real estate sector. An increase was observed after that date. While growth in oil production governed, the economic recovery has been supported by the tourism and hospitality sectors as well as public projects in Abu Dhabi and shallow growth in Dubai’s service sectors. Economic growth reached 5.2 per cent in 2013. The real estate sector has been recovering quickly in some sections, especially in the Dubai residential market.
Data description requires a deep analysis to thoroughly understand the relationship between finance and real economic activity. A new composite indicator was used to measure financial development. The construction of this composite indicator of financial development required that the authors consider a panel of countries. Therefore, the authors choose only 12 countries ranking among the top 15 Islamic financial institutions in 2012, because there is a lack of data on other countries[3]. The results strikingly demonstrated the massive differences in financial development. In fact, the construction of the best practice frontier from the data in the sample reveals that Lebanon and Malaysia generally present the best scores given that they are placed on the frontier during 1990-2002. Malaysia fell below the frontier after 2003. Since 2001, United Kingdom caught up with the best practice frontier countries. Kuwait had a score greater than 0.5 and less than 0.9 during 1990-2003 (except in 1991, the index is equal to 1.00). The UAE, on the contrary, has consistently been below the frontier, implying that it has been unable to attain financial development in line with these countries. The rest of the selected countries also present lower scores: less than 0.5 (Table V).
A Granger causality analysis is used to identify the causality between financial development, Islamic finance and economic growth. A necessary condition of the cointergration and causality is that each variable should be stationary and integrated of same order. Therefore, the first step is to know the degree of integration of each variable by using unit root test (ADF and PP) for the levels and first differences of each variable. The estimated result of this part, reported in Table VI, shows that the null hypothesis of a unit test in the time series cannot be rejected on variable levels in a logarithm form. However, all variables are stationary in their first differences at all significance levels. Therefore, they are integrated of order one, I(1).
As all variables are determined I(1), the second step is to investigate the cointergration relationship among the variables by using Johansen cointergration test. The cointergration rank r of the time series was tested using two tests statistics (Max and Trace).
These tests reject the null hypothesis of no cointergration if the trace statistics or max statistics exceeds the critical value. Table VII shows that the trace statistics as well as the max statistics are less than the critical value of (15.41) and (14.07), respectively, at 95 per cent confidence level for all variables. Therefore, the null hypothesis of no cointergration of variables is accepted at the 5 per cent level of significance.
The results above lead to state the Granger causality. Hence, a bVAR model has been formed and estimated to determine the direction of causality between financial development vs Islamic financial development. Using the AIC, the optimal number of lags is 4. In addition, using this lag length, the residuals in each of the bVAR equations were tested for the normality distribution and for the absence of serial correlation. Table VIII reports the Granger causality tests indicating the direction of the causality[4].
Confirming the findings of King and Levine (1993) and Levine et al. (2000), among others, the authors find that all proxies of financial development positively affect economic growth in the UAE. The statistics show that the composite indicator generates a better result, revealing a highly significant causal relationship between financial development and real economic activity. In fact, development of the financial sector allows for the allocation of savings into long-term assets that are more productive than short-term assets and portfolio diversification for savers and investors. The authors results show a higher ratio of M2 to GDP, which demonstrates deepening financial improvement, although it only stimulates economic growth at the 10 per cent significance level. Domestic credit to the private sector by banks as a percentage of GDP reflects the extent to which savings are liquid. This ratio is related to investment efficiency. It includes only the private sector, which is able to utilize funds more efficiently and productively than the public sector. Higher credit provided by banks, reflecting access to financial resources and the ability to finance new projects, seems to stimulate economic growth in the UAE. It is assumed that foreign investors would interpret an increase in this ratio due to decreased credit constraints as a sign of high confidence of success in the local market – confidence created by commercial banks – thus decreasing the risk of FDI in the UAE. The quality of investments would be improved by FDI inflow. It is also argued that loans provided to the private sector enhance technological innovation, which in turn increases real output.
While the authors’ results indicate one-way causality from credit provided to the private sector to real activity, the results of Al-Malkawi et al. (2012) suggest a bi-directional causality between the same variable measuring intermediation and economic growth. These results are in contrast with the findings of Goaied and Sassi (2010). Their study, conducted for some MENA countries including UAE, shows a non-significant relationship between banking and growth.
The UAE Sovereign Wealth Funds is a significant player in the financial system as well as the real investment stage. The UAE devotes a portion of its reserves to six UAE government-owned investment institutions (Abu Dhabi Investment Authority, Abu Dhabi Investment Council, Mubadala Development Company, International Petroleum Investment Company, Dubai World and Dubai International Capital). These institutions have been prudently investing funds on behalf of the Government with a focus on long-term value creation. They manage a diversified global investment portfolio. It seems that this wealth stimulates the development of the financial sector.
During the period under study, foreign capital was attracted to the region. In addition, higher oil prices during the period are likely to increase loan growth and thus investment. It seems that bank loans have led to improved economic growth.
Furthermore, there are many factors encouraging international companies to do business in the UAE, such as zero tax (except in hydro-carbon and foreign bank branches), relative legal transparency, low political risk, currency pegged to the US dollar, free repatriation of profits, freely transferrable currency, no withholding taxes, first-class infrastructure and a growing economy with investment opportunities. As a result, there has been an increased demand for client account facilities with banks in the UAE, which is likely to lead to more liquidity and thus more financing. Consequently, this capital allocation seems to foster real investment in the country. The UAE banking sector grew about 30 per cent annually during the period 2008-2012 (Deutsch-Emiratisch Industrie and Undelshammer, 2013), making it a principal player in the UAE economy. The global financial crisis in 2008 made the authorities in the UAE focus their attention on the stability and soundness of the financial system by increasing efforts toward reinforcing the financial sector.
Tabash and Dhankar (2014) found a significant bi-directional causality between Islamic banks’ financing and GDP in the UAE. However, Goaied and Sassi (2010) indicated that Islamic banks, similar to the conventional ones, had a weak relation with growth, but tended to act positively as demonstrated theoretically. In line with these studies, the authors’ results indicate only a one-way causality that runs from real GDP to Islamic financial development. This can be explained by the fact that although Islamic finance has grown rapidly, the sector in the UAE is still a niche market within global financial markets. In fact, during the last year of the authors’ period of analysis, the share of Islamic banking in the UAE was between 15 per cent and 18 per cent of the total banking market and less than 20 per cent of the total banking assets. According to the World Islamic Banking Competitiveness Report 2014-2015 (2013-2014), Islamic banking penetration in the UAE stands at 21.4 per cent in 2013 against 18 per cent in 2009 and represents a 14.6 per cent share of the global market. The UAE recorded double-digit shares of 17.4 per cent in 2014. The share of Islamic banking in the UAE is supposed to grow to 50 per cent of the whole market by 2020. The authors may say that the market share of Islamic finance is rising over time with a high degree of robustness and consistency. It is due to the fact that conventional financial institutions have been converted on Islamic basis, partially or completely over recent years (for example, Dubai Bank, National Bank of Sharjah (Sharjah Islamic Bank), Middle East Bank (Emirates Islamic Bank) […]), and there is an increasing demand for Islamic finance services. The whole conversion of the Dubai Financial Market into an Islamic entity is integrated in the UAE’s government strategy.
This result supports the view of Gurley and Shaw (1967) who hypothesize that in developing countries, economic growth leads to the expansion of the financial sector. The table below shows an increase of 83.65 per cent in total deposits (from US$736mn in 1990 to US$62,316mn in 2013)[5] and an investment increase of 77.94 per cent between 1990 and 2013. It seems that total deposits and total investments of Islamic banks are moving together for the long run (Table IX).
The third stage of this study involves the prediction of the future values of the data. Most extrapolative model forecasts assume that the past is a proxy for the future; that is, the economic data for the 2013-2022 period will be driven by the same variables identified during 1990-2012. The bVAR model was applied, and the forecast growth largely coincided with that identified using AIC. The authors estimated the optimal lag length that should be included in the model and obtained 4, except for the financial development composite index, for which the value was 2.
The results of the relevant statistical and econometric tests (residual normality test and autocorrelation test) show that the estimated model meets all econometric criteria. Residual normality (Jarque-Bera statistics) and autocorrelation tests confirm that the bVAR model is satisfactory.
Although forecasting is difficult under the conditions of a relatively short series in a certain period, the results of the presented forecasting models are not negligible, as Figure 4indicates, and could provide important use value for further work in this field. The results show that for real GDP forecasting in the UAE, a group of variables measuring financial development is relevant. The inclusion of a number of variables determining financial development leads to better progress in real economic activity in the long term.
The model seems to explain how changes in a set of variables used as a proxy for financial development can cause economic development. Real GDP and Islamic investment tend to move together over time, as do real GDP and financial development index.
The forecasts suggest that loans to the private sector and in the economy in general will grow during the next 10 years. This result seems to be in line with the intentions of the Government of the UAE to maintain and develop non-oil-sector activity. The depth of the financial sector is likely to help the UAE’s economy to remain strong.
The results predict that the Islamic banking sector will benefit from the strong revival in the UAE’s macroeconomic fundamentals. In particular, non-hydrocarbon real GDP growth in the UAE will continue to show solid expansion, and trade, retail sales and tourism will continue to register strong growth. The real estate and construction sectors also showed recovery in 2012.
The continuous development of the UAE’s financial sector will depend on the progress achieved by financial and institutional reforms, including the rehabilitation of bank balance sheets, restructuring of the non-banking financial sector and improvements in corporate governance and transparency. As presented at the beginning of this section, the soundness of the financial sector is accompanied by a strong rebound in profitability, a decline in non-performing loans (NPLs) and asset growth. The authors’ results are in line with the forecasts of the Institute of International Finance (IIF), where the NPLs-to-total-loans ratio is projected to decline, with strong improvement in capitalization levels, accompanied by an increase in profitability and further easing of liquidity. These soundness indicators will support economic growth in the UAE.
Comparing R_GDP forecasts from VAR models with the predictions of the International Monetary Fund (2015) (Figure 5), it seems that the VAR models provide more accurate forecasts of future GDP observations when financial deepening is considered (Figure 4).
5.Conclusion
The aim of this paper was to study the bivariate causality between economic growth, financial development and Islamic finance in the UAE during 1990-2012. Unit roots tests, a cointergration test and a bivariate vector autoregressive model were used. The paper focuses on a composite index of financial development determined by using data envelopment analysis, a non-parametric approach.
Compared with the 11 countries ranked among the top 15 Islamic financial institutions in 2012, the UAE has consistently been below par, indicating that the country has been unable to attain financial development in line with these countries. Both ADF and PP unit root tests indicated that all variables of interest are I(1). The authors also found that financial development, Islamic finance and economic growth are not cointegrated. In other words, there is no long-term stable relationship between financial development and economic growth in the UAE.
The results of Granger causality test show unidirectional causality from the development of financial system to economic growth. However, Islamic financial institutions in the UAE have benefited from sustainable economic growth. Forecasts for financial development indicate an average year-on-year increase during the period under study, which positively affected economic development.
Despite the economy of the UAE being highly dependent on hydrocarbon revenues, the authors’ analysis revealed that financial development appears to be one of the main drivers of economic growth. The UAE’s capacity to promote Islamic finance will depend largely on economic growth. Reforms that further improve the financial sector could help the UAE to grow its economy faster. The UAE has already made significant progress in building a modern financial sector. It has implemented numerous financial sector policies, including deregulation, interest rate liberalization and the gradual opening up of the financial sector to foreign participation. Therefore, financial development should be pursued as a basic development goal until it reaches the appropriate level. The authors point to the need for recognizing that economic growth and financial development are associated with the increasing strength of the Islamic financial sector.
The results of this study may have a number of limitations. First, the Granger causality analysis did not take into account a structural break in the UAE time series. The inclusion of a structural break in the Granger causality test may improve the number of significant causal relationships. Further research is needed to investigate this effect. Second, the analysis considered the UAE’s overall GDP. There may be further revealing results if the effect of the financial sector on real non-oil GDP growth is considered, in addition to other influences on investment, due to the fall in oil prices or any further potential negative economic factors. Third, as the financial markets in 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 centre for Sukuk activity. Sukuk, as one of the most important tools of the Islamic financial sector, deserves a closer empirical study, which can set the agenda for future work. Fourth, a comparative case study between the UAE and the countries ranked among the top 15 Islamic financial institutions in 2012 could be made. The authors can look at whether countries that are undergoing greater reform in finance are growing faster igure 2(d) confirms that the Islamic banking sector is developing rapidly alongside the conventional system. UAE is emerging as a serious player in the Islamic banking market. However, Figure 2(d) shows a decrease in Islamic investment in 2009. Islamic banks are exposed to risks similar to those of conventional banks where their activity has been affected by the downturn of the global crisis (Zarrouk, 2012). A revival of the economy was observed during 2012.
The UAE continually records a high economic growth rate in an environment with relative price stability. Growth was led mainly by strong tourism activity, the trade and transport sectors and a leaping in real estate activity. These developments reflect the country’s various policies, which contributed to a remarkable expansion of the non-hydrocarbon sector and are expected to bear strong growth going forward.
UAE has continued to reap benefits from its safety shelter status. Figure 3 shows a decrease of the real GDP during 2009-2010 with a defection of the real estate sector. An increase was observed after that date. While growth in oil production governed, the economic recovery has been supported by the tourism and hospitality sectors as well as public projects in Abu Dhabi and shallow growth in Dubai’s service sectors. Economic growth reached 5.2 per cent in 2013. The real estate sector has been recovering quickly in some sections, especially in the Dubai residential market.
Data description requires a deep analysis to thoroughly understand the relationship between finance and real economic activity. A new composite indicator was used to measure financial development. The construction of this composite indicator of financial development required that the authors consider a panel of countries. Therefore, the authors choose only 12 countries ranking among the top 15 Islamic financial institutions in 2012, because there is a lack of data on other countries[3]. The results strikingly demonstrated the massive differences in financial development. In fact, the construction of the best practice frontier from the data in the sample reveals that Lebanon and Malaysia generally present the best scores given that they are placed on the frontier during 1990-2002. Malaysia fell below the frontier after 2003. Since 2001, United Kingdom caught up with the best practice frontier countries. Kuwait had a score greater than 0.5 and less than 0.9 during 1990-2003 (except in 1991, the index is equal to 1.00). The UAE, on the contrary, has consistently been below the frontier, implying that it has been unable to attain financial development in line with these countries. The rest of the selected countries also present lower scores: less than 0.5 (Table V).
A Granger causality analysis is used to identify the causality between financial development, Islamic finance and economic growth. A necessary condition of the cointergration and causality is that each variable should be stationary and integrated of same order. Therefore, the first step is to know the degree of integration of each variable by using unit root test (ADF and PP) for the levels and first differences of each variable. The estimated result of this part, reported in Table VI, shows that the null hypothesis of a unit test in the time series cannot be rejected on variable levels in a logarithm form. However, all variables are stationary in their first differences at all significance levels. Therefore, they are integrated of order one, I(1).
As all variables are determined I(1), the second step is to investigate the cointergration relationship among the variables by using Johansen cointergration test. The cointergration rank r of the time series was tested using two tests statistics (Max and Trace).
These tests reject the null hypothesis of no cointergration if the trace statistics or max statistics exceeds the critical value. Table VII shows that the trace statistics as well as the max statistics are less than the critical value of (15.41) and (14.07), respectively, at 95 per cent confidence level for all variables. Therefore, the null hypothesis of no cointergration of variables is accepted at the 5 per cent level of significance.
The results above lead to state the Granger causality. Hence, a bVAR model has been formed and estimated to determine the direction of causality between financial development vs Islamic financial development. Using the AIC, the optimal number of lags is 4. In addition, using this lag length, the residuals in each of the bVAR equations were tested for the normality distribution and for the absence of serial correlation. Table VIII reports the Granger causality tests indicating the direction of the causality[4].
Confirming the findings of King and Levine (1993) and Levine et al. (2000), among others, the authors find that all proxies of financial development positively affect economic growth in the UAE. The statistics show that the composite indicator generates a better result, revealing a highly significant causal relationship between financial development and real economic activity. In fact, development of the financial sector allows for the allocation of savings into long-term assets that are more productive than short-term assets and portfolio diversification for savers and investors. The authors results show a higher ratio of M2 to GDP, which demonstrates deepening financial improvement, although it only stimulates economic growth at the 10 per cent significance level. Domestic credit to the private sector by banks as a percentage of GDP reflects the extent to which savings are liquid. This ratio is related to investment efficiency. It includes only the private sector, which is able to utilize funds more efficiently and productively than the public sector. Higher credit provided by banks, reflecting access to financial resources and the ability to finance new projects, seems to stimulate economic growth in the UAE. It is assumed that foreign investors would interpret an increase in this ratio due to decreased credit constraints as a sign of high confidence of success in the local market – confidence created by commercial banks – thus decreasing the risk of FDI in the UAE. The quality of investments would be improved by FDI inflow. It is also argued that loans provided to the private sector enhance technological innovation, which in turn increases real output.
While the authors’ results indicate one-way causality from credit provided to the private sector to real activity, the results of Al-Malkawi et al. (2012) suggest a bi-directional causality between the same variable measuring intermediation and economic growth. These results are in contrast with the findings of Goaied and Sassi (2010). Their study, conducted for some MENA countries including UAE, shows a non-significant relationship between banking and growth.
The UAE Sovereign Wealth Funds is a significant player in the financial system as well as the real investment stage. The UAE devotes a portion of its reserves to six UAE government-owned investment institutions (Abu Dhabi Investment Authority, Abu Dhabi Investment Council, Mubadala Development Company, International Petroleum Investment Company, Dubai World and Dubai International Capital). These institutions have been prudently investing funds on behalf of the Government with a focus on long-term value creation. They manage a diversified global investment portfolio. It seems that this wealth stimulates the development of the financial sector.
During the period under study, foreign capital was attracted to the region. In addition, higher oil prices during the period are likely to increase loan growth and thus investment. It seems that bank loans have led to improved economic growth.
Furthermore, there are many factors encouraging international companies to do business in the UAE, such as zero tax (except in hydro-carbon and foreign bank branches), relative legal transparency, low political risk, currency pegged to the US dollar, free repatriation of profits, freely transferrable currency, no withholding taxes, first-class infrastructure and a growing economy with investment opportunities. As a result, there has been an increased demand for client account facilities with banks in the UAE, which is likely to lead to more liquidity and thus more financing. Consequently, this capital allocation seems to foster real investment in the country. The UAE banking sector grew about 30 per cent annually during the period 2008-2012 (Deutsch-Emiratisch Industrie and Undelshammer, 2013), making it a principal player in the UAE economy. The global financial crisis in 2008 made the authorities in the UAE focus their attention on the stability and soundness of the financial system by increasing efforts toward reinforcing the financial sector.
Tabash and Dhankar (2014) found a significant bi-directional causality between Islamic banks’ financing and GDP in the UAE. However, Goaied and Sassi (2010) indicated that Islamic banks, similar to the conventional ones, had a weak relation with growth, but tended to act positively as demonstrated theoretically. In line with these studies, the authors’ results indicate only a one-way causality that runs from real GDP to Islamic financial development. This can be explained by the fact that although Islamic finance has grown rapidly, the sector in the UAE is still a niche market within global financial markets. In fact, during the last year of the authors’ period of analysis, the share of Islamic banking in the UAE was between 15 per cent and 18 per cent of the total banking market and less than 20 per cent of the total banking assets. According to the World Islamic Banking Competitiveness Report 2014-2015 (2013-2014), Islamic banking penetration in the UAE stands at 21.4 per cent in 2013 against 18 per cent in 2009 and represents a 14.6 per cent share of the global market. The UAE recorded double-digit shares of 17.4 per cent in 2014. The share of Islamic banking in the UAE is supposed to grow to 50 per cent of the whole market by 2020. The authors may say that the market share of Islamic finance is rising over time with a high degree of robustness and consistency. It is due to the fact that conventional financial institutions have been converted on Islamic basis, partially or completely over recent years (for example, Dubai Bank, National Bank of Sharjah (Sharjah Islamic Bank), Middle East Bank (Emirates Islamic Bank) […]), and there is an increasing demand for Islamic finance services. The whole conversion of the Dubai Financial Market into an Islamic entity is integrated in the UAE’s government strategy.
This result supports the view of Gurley and Shaw (1967) who hypothesize that in developing countries, economic growth leads to the expansion of the financial sector. The table below shows an increase of 83.65 per cent in total deposits (from US$736mn in 1990 to US$62,316mn in 2013)[5] and an investment increase of 77.94 per cent between 1990 and 2013. It seems that total deposits and total investments of Islamic banks are moving together for the long run (Table IX).
The third stage of this study involves the prediction of the future values of the data. Most extrapolative model forecasts assume that the past is a proxy for the future; that is, the economic data for the 2013-2022 period will be driven by the same variables identified during 1990-2012. The bVAR model was applied, and the forecast growth largely coincided with that identified using AIC. The authors estimated the optimal lag length that should be included in the model and obtained 4, except for the financial development composite index, for which the value was 2.
The results of the relevant statistical and econometric tests (residual normality test and autocorrelation test) show that the estimated model meets all econometric criteria. Residual normality (Jarque-Bera statistics) and autocorrelation tests confirm that the bVAR model is satisfactory.
Although forecasting is difficult under the conditions of a relatively short series in a certain period, the results of the presented forecasting models are not negligible, as Figure 4indicates, and could provide important use value for further work in this field. The results show that for real GDP forecasting in the UAE, a group of variables measuring financial development is relevant. The inclusion of a number of variables determining financial development leads to better progress in real economic activity in the long term.
The model seems to explain how changes in a set of variables used as a proxy for financial development can cause economic development. Real GDP and Islamic investment tend to move together over time, as do real GDP and financial development index.
The forecasts suggest that loans to the private sector and in the economy in general will grow during the next 10 years. This result seems to be in line with the intentions of the Government of the UAE to maintain and develop non-oil-sector activity. The depth of the financial sector is likely to help the UAE’s economy to remain strong.
The results predict that the Islamic banking sector will benefit from the strong revival in the UAE’s macroeconomic fundamentals. In particular, non-hydrocarbon real GDP growth in the UAE will continue to show solid expansion, and trade, retail sales and tourism will continue to register strong growth. The real estate and construction sectors also showed recovery in 2012.
The continuous development of the UAE’s financial sector will depend on the progress achieved by financial and institutional reforms, including the rehabilitation of bank balance sheets, restructuring of the non-banking financial sector and improvements in corporate governance and transparency. As presented at the beginning of this section, the soundness of the financial sector is accompanied by a strong rebound in profitability, a decline in non-performing loans (NPLs) and asset growth. The authors’ results are in line with the forecasts of the Institute of International Finance (IIF), where the NPLs-to-total-loans ratio is projected to decline, with strong improvement in capitalization levels, accompanied by an increase in profitability and further easing of liquidity. These soundness indicators will support economic growth in the UAE.
Comparing R_GDP forecasts from VAR models with the predictions of the International Monetary Fund (2015) (Figure 5), it seems that the VAR models provide more accurate forecasts of future GDP observations when financial deepening is considered (Figure 4).
5.Conclusion
The aim of this paper was to study the bivariate causality between economic growth, financial development and Islamic finance in the UAE during 1990-2012. Unit roots tests, a cointergration test and a bivariate vector autoregressive model were used. The paper focuses on a composite index of financial development determined by using data envelopment analysis, a non-parametric approach.
Compared with the 11 countries ranked among the top 15 Islamic financial institutions in 2012, the UAE has consistently been below par, indicating that the country has been unable to attain financial development in line with these countries. Both ADF and PP unit root tests indicated that all variables of interest are I(1). The authors also found that financial development, Islamic finance and economic growth are not cointegrated. In other words, there is no long-term stable relationship between financial development and economic growth in the UAE.
The results of Granger causality test show unidirectional causality from the development of financial system to economic growth. However, Islamic financial institutions in the UAE have benefited from sustainable economic growth. Forecasts for financial development indicate an average year-on-year increase during the period under study, which positively affected economic development.
Despite the economy of the UAE being highly dependent on hydrocarbon revenues, the authors’ analysis revealed that financial development appears to be one of the main drivers of economic growth. The UAE’s capacity to promote Islamic finance will depend largely on economic growth. Reforms that further improve the financial sector could help the UAE to grow its economy faster. The UAE has already made significant progress in building a modern financial sector. It has implemented numerous financial sector policies, including deregulation, interest rate liberalization and the gradual opening up of the financial sector to foreign participation. Therefore, financial development should be pursued as a basic development goal until it reaches the appropriate level. The authors point to the need for recognizing that economic growth and financial development are associated with the increasing strength of the Islamic financial sector.
The results of this study may have a number of limitations. First, the Granger causality analysis did not take into account a structural break in the UAE time series. The inclusion of a structural break in the Granger causality test may improve the number of significant causal relationships. Further research is needed to investigate this effect. Second, the analysis considered the UAE’s overall GDP. There may be further revealing results if the effect of the financial sector on real non-oil GDP growth is considered, in addition to other influences on investment, due to the fall in oil prices or any further potential negative economic factors. Third, as the financial markets in 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 centre for Sukuk activity. Sukuk, as one of the most important tools of the Islamic financial sector, deserves a closer empirical study, which can set the agenda for future work. Fourth, a comparative case study between the UAE and the countries ranked among the top 15 Islamic financial institutions in 2012 could be made. The authors can look at whether countries that are undergoing greater reform in finance are growing faster
Notes
1.. The Decision Making Units convert multiple inputs into multiple outputs.
2.. For more details, see Zrelli and El Ghak (2014).
3.. Available at: www.thebanker.com/Reports/Special-Reports/Top-500-Islamic-financial-institutions. · 4.. We tested the stationarity of the index and we performed the co-integration test. Results, not reported, are similar to those found for the other variables.
5.. Source: Authors’ calculation and IBIS data base. R
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Type: Research Paper
Publisher: Emerald Publishing Limited
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