Presented By:

Mariyam Sikandar BC18-090

Iqra Imran BC18-067

Shumail Yousaf BC18-080

Submitted to:
DR. Prof Rao Zia ur Rehman
Subject: Business and Finance in Islam
Section: B(morning)
Semester: 7th
B.com (honors)
 Islamic Finance and Economic Growth

Introduction

Every country of the world is depending on its religious sentiments, socio-

cultural and economic attributes. The Prosperity of the country is all about its
economic prosperity and economic prosperity is the result of various economic
variables such as human resources, financial resources, and technological
resources, etc. The Financial sector plays a very important role in any economy.
Islamic Finance is one of the fastest-growing sectors of the global banking
industry and has risen because of its special and unique characteristics. In a time
where the global market is suffering from extreme turbulence in wake of credit
pressure and many banking crises, we should consider the merits of an
alternative banking model which adopts a different attitude to risk and finance,
based on the principles of SHARIAH (the Path, term of Islamic law consist of
instructions based on the Holy Quran and Sunnah). Money is viewed as a
measuring instrument for worth rather than an “asset” in SHARAH law. It
prohibits the receipt and payment of Riba (interest), gharar (extreme
uncertainty), maysir(gambling), and short sales of financing operations that are
deemed damaging to society. The key difference between both the systems is
that conventional banking is based on the ‘RIBA’ system and Islamic Banking is
free from it.
History:
Islamic finance was considered as a new phenomenon in the global financial
scenario in the 1970s, starting with the establishment of the first Islamic
commercial bank, namely Dubai Islamic Bank in 1975. In the beginning, because
of the instability of the policies banking sectors has faced a difficult time. Since
then, the Islamic finance industry continues to record remarkable progress.
Young’s World Islamic Banking Competitiveness Report 2013 said global
Islamic banking assets, with more than 500 Islamic institutions working in more
than 75 countries, are expected to reach U. S$1.8 TRILLION by 2014, up from
$1.3 t f
assets held in 2011. And also have an annual growth of 17.6% in the period 2009
and 2013.
In Pakistan, Islamic Banking is the new arrival of the banking system and it create
a competitive environment for Conventional Banking. Meezan was the first
registered Islamic Bank in Pakistan (2002).

There is no doubt that financial sector development plays an important role in the
overall development of an economy. Many economists have maintained that the
development and efficiency of the financial system are closely linked to economic
growth.
Islamic banking and finance are well and truly established as one of the world's
fastest-growing economic sectors. Islamic finance involves structuring financial
instruments and financial transactions to satisfy traditional Muslim structures
against the payment of interest and engaging in gambling.
Islamic Finance is a field of growing importance for Muslims, especially in the
Middle East and large Muslim population in the South-Eastern Asia countries who
are uncomfortable with Western-Style of financial system and banking which
involve explicit payments of interest.
The actual success for the Islamic Bank is to provide complete knowledge about
their profit and loss sharing concept and to remove misconception which is
prevailing in the market.
The Islamic modes of financing are (Murabaha, Ijarah, Ijarah-wal-iqtina, Musa
Wamah, Istisna, Mudarabah, Musharakah).
Showing a high level of Islamic Banking sector assets in the history, its
increasing market share as its active financial intermediation role, both in
Malaysia and globally, it is timely and highly relevant to assess the contribution
of Islamic finance the real economy. This need is particularly important in the
case of
Malaysia and the Middle East where Islamic finance is being positioned to play an
increasingly important role in the economy. More importantly, the countries have
frequently been set as a benchmark for other regions aspiring to develop their
Islamic banking and finance sectors.
Despite the strategic role of Islamic finance to the Malaysian and Middle East
economies and the important position it occupies in the global Islamic finance
industry, only a few studies have been focusing on the Islamic financial sector to
the real economy. This study seeks to fill the literature gap by investigating the
relationship in a multi-variate context by including not just the Islamic banking
indicators and economic output variables, but other variables that potentially
have a significant influence on the development of the Islamic Finance industry.
Additionally, the study hopes to shed light on the nature of short and long-run
relationships between Islamic Finance and economic activity. The result also
indicates improvement of Islamic financial institutions for economic welfare and
also for poverty reduction

Literature Review:
Islamic finance and economic growth have been some of the most popular issues
in the finance sector. The literature review is based on merging the two different
articles. The first is Middle East Perspectives, and the second is Malaysian
Experience.
In the Middle East, some authors consider financing an important factor for
growth, while other authors think that finance is only a minor factor for growth.
An author, Patrick, also contributes to this literature. He identifies two possible
patterns that link the relationship between financial development and economic
growth. The first one is the demand-following, which indicates that the financial
assets of these institutions and liabilities, as well as financial services associated
with them, are a response to investors and savers in the United States. In the
United States, there is a high demand for these services. Thus, this pattern
indicates that the financial system can be improved and can support the leading
sectors in the process of growth. The second is known as supply-leading, which
means that the supply of financial assets of these institutions and liabilities, and
related financial services are in advance of demand for them. One is that it moves
resources from conventional sectors (non-growth) to modern sectors (growth),
and the other is that it promotes entrepreneurial activity in these sectors.
Some other authors say that my savings and facilitating investment the economic
growth can be promoted with developed financial markets. While some say that
banking is the tool of economic growth due to its productive funding
investments. There are not too many studies that examine the role of Islamic
finance in economic growth. In the Middle East countries, some limited articles
are done by some different authors.
The Development of the Islamic financial system plays a vital role in the economic
growth of a country. According to the monetary policies of each country, the
relationship between the Islamic finance and economic growth is different from
each other. There is also a drawback that most of the studies use a short period
and most analyze only one Islamic bank for each country.
All the above studies are done in South-East Asia countries. They have
investigated the financing of the total Islamic banks for all the Islamic banks in the
selected countries for the Middle east to adequate the number of data that
can be calculated in a reasonable time. This study has selected the most
reasonable countries from the Middle East in which Islamic finance has a major
growth.
In Malaysian Experience, they think that economists are divided on the nature
the relationship between finance and growth. They have merged the four
hypotheses regarding this, the supply-leading hypothesis, demand-following
hypothesis, mutual dependency hypothesis, and the neutrality hypothesis. The
supply-leading hypothesis claims that the factor which leads towards economic
growth is the development of Islamic finance. On the other side, the demand-
following hypothesis says that the expansion of economic growth leads towards
Islamic financial development. In 1996 an author proposed the mutual
dependency hypothesis which says that there is a link between the progress of
finance and economic growth. Later on, a dispute aroused that finance drives
economic growth in the developing countries but in highly developing countries
finance simply follows demand. Late in 1998 an author argued on this dispute
and introduced the hypothesis of neutrality, he says that finance is not always an
important part of the process of growth. He also claims that there is an over-
stressed link between growth and finance.
Another author in Malaysia, evaluated the relationship between the economic
growth and the development of Islamic banking and also, the relationship
between the formation of capital and development of Islamic banking using the
data collected from 1998 to 2012. They did a test of non-causality, the result of
the test shows that when Islamic finance develops in Malaysia, it will contribute
to the country’s economic growth.
The studies that are discussed above illustrate that the external sector is
important while external trade has an impact on the real economy. These studies
have a flow in them because they ignore the reality that Islamic finance
development and economic growth are typically measured by inflation. But the
current analysis tries to fill this gap by examining the Islamic finance effect on the
Malaysian economy.

Research Methodology:
The goal of research methodology is to explain why both the studies chose the
way they did for their research. A backup of their data gathering methods,
analytic methodologies, aspects, and answering the research questions.
In the middle east, they have collected data from the World Trade Organization,
Global Development Finance, Islamic Banks Financial Institutions Information
Databases for the financing of all the Islamic banks selected in the Middle East
nations. Depending on the availability of data they have employed two time
periods one for Bahrain and Qatar that was used to understand the relationship
between Islamic banks and GDP from 1990 to 2008. And the other was used to
understand the relationship between the Islamic banks financing and GDP in UAE
from 1990 to 2010. According to them in the studies on finance and growth, GDP
is an indicator of economic growth.
The study’s initial stage is to assess the link between Islamic banking and the
growth of the economy. They have used the time series for the evaluation in
the model and as result, they calculated the logarithm of the time series. They
did a test of unit root to examine the data and discovered that the data was not
stationary.
Furthermore, the study also answers the questions like is there any significant
relationship between growth and Islamic finance development? Does financial
development lead to economic growth or does economic growth leads to
financial development in the middle east selected countries?
In Malaysian Experience, the research methodology of Malaysian was based on
two different approaches, variable and data sources and estimating model.
According to variables and data sources, the industrial output index is used to
reflect the economic activities. It is appropriate to give a theoretical relationship
between Islamic banking and growth activities. There are two indicators for the
development of Islamic financing which are used as independent variables. The
first indicator is used to capture the Islamic bank’s capacity from the units of an
economy with the help of its total deposits in the Islamic banks. And the second
indicator of financing is used to check the ability of Islamic banks to finance
economic growth.
These indicators are chosen because they fulfill the Shariah-compliant financing
tools that are used to allocate funds by Islamic banks.

Some other variables are also added to the model to compensate for the
problem of bias owing to missing variables. Government spending may result in a
budget deficit whereas inflation shows the stability of price in the economy which
influences savings, deposits, investment decisions, and financing provided by
Islamic banks.
The estimating model approach is used in this study to the link between Islamic
finance (banking) and economic growth. This approach was chosen to have a unit
root when financial time series tend to do so. Another need for using this
approach is that the variables can be integrated in the same order. Serial
correlation test, normality test, and stability test are used in this case.
There is an increase in industrial production of 0.152% and a 1% increase in
Islamic bank financing due to the impact of financial development on economic
growth. Financial development has a consistent contribution towards the
principles of Islamic finance.
Results:
Several studies have focused on the particular role that Islamic finance may play
in the economic growth process. Islamic banking and finance have begun to gain
in more than 75 countries throughout the world. On this contribution, the
research has been limited to economic growth in the countries.
A strong and successful sector can provide Islamic banks with additional returns
by allowing them to grow more. It is a basic responsibility of all Islamic financial
institutions in the case where other institutions in an Islamic economy are
supporting economic growth.
In the Middle East, it is clear that Islamic banks financing and economic growth
are linked. They did the non-causality test and null hypothesis in the selected
countries of the middle east. The result shows the probability of 0.01559 is less
than 0.05 because one-way causality exists from Islamic bank financing to
economic growth. As a result, the null hypothesis is rejected, and it can be argued
that the increase in the flow of Islamic finance has contributed to economic
growth in the selected countries of the middle east.
In the Malaysian Experience, the results show that in the short run, Islamic bank
deposits have little influence on industrial production. They also found a lag
between receiving deposits and funds for economic growth. Various financial
operations help to limit and diversify risks to ensure that funds are distributed to
deserving investment opportunities.
The findings also suggest that the activities of financing Islamic banks contribute
to significant economic growth in both the short term and long term. With a
stronger impact in the long term. This data implies that Malaysian Islamic banks
are performing their financial activities effectively.
Conclusion:
The conclusion is based on combining the two different Articles. The first article is
about the middle east and the second article is Malaysian. Both articles have a
different point of view and rules in Islamic finance and economic growth.
In the Middle East:
This paper attempts to examine the relationship between the development of the
Islamic financial system and economic growth in the long term in the selected
countries of the Middle East. We analyzed empirically the relationship between
Islamic bank financing and economic growth using econometric
analysis. Therefore, Johansen, s co-integration technique has been applied. The
co-integration results provide evidence of a unique integration vector. In other
words, there is a long-term stable relationship between Islamic banks,
financing, and economic growth in the three countries under the
study. That means Islamic banks’ financing and economic growth move together
in the long run. It is proved that the Middle East has benefited from a strong
banking system. We also find that the causality relation exists in a bi-directional
relationship from Islamic
Banks financing to economic growth and vice versa for Bahrain and Qatar. we
also find that the causality relation exists in the Islamic banks financing to
economic growth in a unique direction from the development of a financial
system to economic growth, but not in the opposite direction in UAE. Our results
also indicate that the improvement of the Islamic financial institutions in the
middle east will benefit economic development and it is critical in the long run
for economic welfare, and also for poverty reduction. The result of the study is
quite significant as it is one of the pioneering studies of Islamic finance.
In Malaysian:
The high proportion of Islamic banking assets and their increasing presence and
significance in the Malaysian financial sector has called for the evaluation of the
role of the sector in enhancing the real economy of the country. The results also
show that Islamic banks financing activities are making a significant contribution
to the real economic activities both in the short and long run, with the long-run
contribution being stronger. This finding suggests that the economic banks in
Malaysian are effectively caring out the financial intermediation role of polling
and channeling funds to productive investment activities.
The above contributions of Islamic finance to the real economic activities are
made possible by the principle of equity participation embedded in tithe
investor-investee relation between the depositors and the Islamic banks based
on the concept risk-sharing should lead to better monitoring of investment,
hence higher productivity, more stable financial sector due to absence of interest
rate risk, among other and hence more sustainable economic growth. These
features
are evident in the various Islamic finance instruments, such as Mudharaba (profit
sharing), Musharakah (joint venture), and ijarah (leasing) among other
instruments.

For example, mudharaba and musharakah are both long-term financing

arrangements devoid of interest, in which profit/ loss is shared among the saver
and entrepreneur based on the appropriate ratio. They also involved the
participation of both parties right from deciding the type of project to be
undertaken to its implementation, hence proper monitoring is ensured. The
implications of these findings to the practice of Islamic banking in Malaysian are
that, given the lack of and weak contributions of Islamic banks, deposits to the
real economy in the short and long run, respectively, the bank need to design
longer-term instruments of deposits such as the counterpart of the negotiable
certificate of deposits in the conventional banking.
For the financing aspect, although it contributes to industrial production in both
the short and long runs, the long-run effect is shown to the stronger than the
short run, thus the banks need to balance their funds’ allocation for take-up and
business expansion purposes. Although, deposit and financing are supposed to
be
closely linked in Islamic banking, these findings suggested
otherwise, therefore, the bank should take measures to bridge the gap.
Because of the important contribution of Islamic finance to the Malaysian
economy, continuous efforts need to be undertaken to further expand the
industry. on top of the list is the importance of a conducive legal and regulatory
framework that needs to be further refunded to support the transformation of
the Malaysian Islamic finance industry to become a global industry, thus further
strengthening the country’s position as an exemplary role and a leader in
promoting Islamic finance the global level.