1

THE CONTRIBUTION OF ISLAMIC BANKING

AND FINANCIAL INSTITUTIONS (IBFIs)
TO THE INDONESIAN ECONOMIC GROWTH:
The Evidence from the ARDL Bound Testing Approach
(Periods 2002.Q4 to 2010.Q2)
1
Shochrul Rohmatul Ajija,
2
Rahmat Heru Setianto and
3
Ahmad Hudaifah
ABSTRAK
Penelitian empiris terkait pengaruh jangka pendek dan jangka panjang sektor
keuangan terhadap pertumbuhan ekonomi suatu negara telah banyak dilakukan.
Namun demikian, mayaritas studi empiris tersebut masih menggunakan analisis
kointegrasi Johansen-Juselius atau Engel-Granger. Sementara itu, pendekatan
kointegrasi mutakhir yakni autoregressive distributed lag (ARDL), yang
merupakan penyempurnaan dari beberapa pendekatan analisis kointegrasi
sebelumnya masih jarang dilakukan terutama di Indonesia. Oleh karena itu,
penelitian ini difokuskan untuk menguji kontribusi perbankan dan institusi
keuangan berbasis shariah terhadap pertumbuhan ekonomi di Indonesia. Hal ini
dilakukan karena sektor keuangan shariah di Indonesia mengalami pertumbuhan
yang spektakuler terutama pada satu dekade terakhir. Penelitian ini tidak hanya
menggunakan metode kointegrasi yang terbaru yakni ARDL, tetapi juga
menggunakan analisis kointegrasi yang umum dipakai yakni tes kointegrasi
Johansen-Juselius. Dari kedua metode tersebut dapat diambil kesimpulan bahwa
sektor keuangan shariah masih belum memiliki pengaruh jangka pendek dan
jangka panjang yang signifikan terhadap pertumbuhan ekonomi di Indonesia.
Lebih dari itu, pertumbuhan ekonomi di Indonesia nampaknya lebih bisa
dijelaskan oleh Jakarta Islamic Index dan inflasi. Namun demikian,
pertumbuhan ekonomi mengalami peningkatan ketika merespon inovasi pada
total deposito dan total dana pihak ketiga dari perbankan shariah. Hal ini berarti
bahwa perbankan shariah di Indonesia memiliki peluang yang cukup bagus
untuk berkontribusi pada pertumbuhan ekonomi secara aggregat. Oeh karena
itu, perbankan shariah di Indonesia harus lebih digiatkan seperti yang telah
terjadi di Malaysia, dimana sektor keuangan shariah telah mampu memberikan
kontribusi yang sangat besar terhadap total perekonomian.
1
Master student of economics, International Islamic University Malaysia (IIUM), e-mail:
shochrul.rohma@gmail.com
2
Lecturer at Airlangga University, e-mail: rahmat.setianto@yahoo.com
3
Master student of economics, IIUM, e-mail: benzalurraman@yahoo.com
2
1. Introduction
The empirical studies with respect to the relationship between financial and real
sectors have been well-established in the last few decades. Prior studies conducted
by Porter (1966), Goldsmith (1969), King and Levine (1993), Lenive and Zervos
(1998), Chen (2002), Wa (2002), Fischer (2003), Escenbach (2004), and Zhuang
et al. (2009) indicate that components of conventional financial development
robustly have positive impact to the real sector, i.e. economic growth. Meanwhile,
Al-Tamimi, et al (2001), Al-Yousif (2002), Levine (2004), and Berrospide and
Edge (2009) assert that there is no relationship between financial intermediaries
and economic growth.
In Indonesia, the impact of the financial sectors on economic growth has
also been analyzed by some scholars for example Mulyadi (2004), Inggrid (2006),
and Azansyah (2008). Nevertheless, the evidences on the contribution of financial
sector to economic growth have received much attention and been debated. This is
because the earlier studies found mixed and inconclusive results positively
related, independent and not causally related, unidirectional and bidirectional
causalities (Majid and Salina Kassim, 2010).
Despite numerous studies focusing on the contribution of the financial
sectors to economic growth, very few studies examining the contribution of the
Islamic banking and financial institutions (IBFIs) especially in Muslim countries
such as Indonesia whereas to economic growth. In addition, the previous studies
concerned in this area have utilized some cointegration methods such as the two-
step residual-based procedure for testing the null of no-cointegration (see Engle
and Granger, 1987) and the system-based reduced rank regression approach due to
Johansen (1991). Only a few studies concerned on a new approach testing for the
existence of a relationship between variables in levels which is applicable
irrespective of whether the underlying regression are purely I(0), purely I(1) or
mutually cointegrated which is called the autoregressive distributed lag (ARDL)
modeling approach (Pesaran et al., 2001).
Majid and Kassim (2010) have been assessing the contribution of Islamic
banking and financial institutions (IBFIs) in the Malaysian economy by using
3
ARDL approach. According to them, this methodology is the best approach to
explain the cointegration beyond the existing literature especially in Malaysia.
This is because the previous methods such as Engle-Granger and Johansen-
Juselius cointegration test suffered several drawbacks. Pesaran et al. (2001) argue
that all of these methods concentrate on cases in which the underlying variables
are integrated of order one. This inevitably involves a certain degree of pre-
testing, thus introduces a further degree of uncertainty in the analysis of the
relationships in level.
Therefore, this study attempts to utilize ARDL approach to assess the
contribution of IBIFs in the Indonesian economy which replicates the model used
by Majid and Kassim (2010). Nevertheless, dissimilar with Majid and Kassim
(2010) this paper uses the Johansen-Juselius cointegration test as well as Vector
Error Correction Model (VECM) to compare the result of this paper and the
previous ones.
Accordingly, the objectives of this study are to: 1) asses the contribution
of IBFs to promote economic growth in Indonesia; 2) explore the nature of the
relationship between IBFs and economic growth in Indonesia; and 3) examine the
relationships between IBFs and the Indonesian economic growth in the short and
long run.
In the second section, this paper quotes some literature review about banks
in the financial system and previous studies related with the topic. Section 3
presents an empirical framework for assessing the contribution of IBFs to
economic growth in Indonesia. Then, section 4, describes preliminary analysis of
the data used and present results of preliminary analysis. Lastly, section 5
summarizes the main findings and their implications.
2. Literature Review
Bank as Intermediary Institutions
Financial system emerges because of the mismatch between income and spending,
both individual and company and creates the surplus and deficit units (Hubbard,
4
2002). In the complex financial system, the fund is shifted from the surplus unit
into the deficit unit through the certain mechanism and fuels the economy activity.
Actually, the surplus unit can meet directly with the deficit unit without
intermediary, called direct finance. By agreement, the deficit unit issues a
financial claim or a security such as stock, bond or commercial paper to the
surplus unit for the loan evidence. In this case financial claim appears as a
primary security because of directly claim shifting.
One model of direct finance is stock exchange transaction. The agents are
companies that need funding for business expansion while the investors are the
ones who want to invest their funds in order to have a higher return in the future.
Another opinion said that stock companies or mutual fund companies involve in
the stock market as the model of semi-direct finance. Both models function as the
information providers about the possibility of selling and purchasing securities
(broker) or called dealer. In this case, someone purchase primary securities from
the companies that need funding then sell them to the prospective investors with a
higher cost. It is called as a semi-direct finance because the stock company or
reksadana (in an Indonesian terminology) or mutual fund companies performs an
intermediary function, broker or dealer.
On the other hand, the surplus unit meets the deficit unit through
intermediaries. Financial intermediaries stand as the intermediary or perform an
indirect finance. Financial intermediaries or financial institutions are corporations
in which their main wealth is formed by financial assets or claims in comparison
with the non-financial assets or real assets (Siamat, 2004). The funds collected
from the public will be re-distributed in the form of credits and will be invested in
the commercial papers. Such collected funds came from the finance products and
services of the financial institutions such as clearing accounts, savings, life
insurance, and pension planning.
Financial intermediaries are classified by various ways. The general
classification is based on the ability of directly collecting funds from the public.
This could be further classified into two categories. First of all are the deposit
intermediary institutions or bank financial institutions. They directly collect and
5
distribute funds from the public in the form of savings, for instance, clearing
accounts, savings and life insurance. The financial institution that offers this
service is called a bank. Secondly, the non-depository intermediary institutions or
non-bank financial institutions, it has functioned as the fund collectors and
distributors of funds from and into the public (Siamat, 2004).
Bank is a corporation that collects funds from the public and re-distributes
them to the entrepreneurs in the form of credits or other forms in order to improve
the standard of life of the society (UU No 7/ 1992 about banking as transformed
with UU No 10/ 1980. Thus, bank is part of the financial institutions functioning
as financial intermediary and connecting the excess of funds and the shortage of
funds.
Abdullah and Suseno (2003) analyze about the intermediary function of
banking in the region and identify the affecting factors after the decentralization
system was undertaken (the implementation of UU No 22 and 25/ 1999 about
decentralization). Using shift and share analysis, the study concludes that Loan to
Deposit Ratio (LDR) should not be used as the only parameter for analyzing the
effectiveness of regional banks intermediary function. In addition, the study also
asserts that the decentralization of banking (the changing of branch office banking
into banking unit office) has a positive impact toward banking intermediary.
Using Ordinary Least Square (OLS) method, Haddan et al. (2004) studies
the role of foreign banks toward the development of Indonesian economy,
especially from the indicator of credit distribution point of view. The performance
of foreign banks is compared with joint venture and regional banks in order to
know the role of each bank toward national economic growth. Besides that, the
performance and arrangement of foreign banks in Indonesia are also compared
with the condition of other countries such as Malaysia, Thailand, China and
Canada.
Mintaroem (2003), using OLS, analyze how the profile of murabahah and
mudharabah financing in shariah banking in Indonesia during 1998-2003 is; how
the condition of shariah banks related to both financing products (murabahah and
mudharabah), obstacles, and the prospects in the future is; and how to know the
6
condition and position of the murabahah financing in the beginning of its
development in Indonesia, with input some independent variables such as third-
party fund, inflation rate, credit interest rate of conventional banks, and bonus for
wadiah fund placement. The empiric result shows that bonus of wadiah fund
placement does not significantly influence the growth of murabahah financing,
but it only affects the mudharabah financing.
Financial Sector and Economic Growth
Finance affects economic growth, stagnation or even decline in any economic
system (Nzotta, 2009 and Shan and Jianhong, 2006). Some prior studies have
shown that there is a strong and positive relationship between the financial sector
and economic growth. King and Levine (1993) conclude that financial
development leads economic growth. Lenive and Zervos (1998) found that
stock market and banking development leads economic growth. According to
Porter (1966) the level of financial institution development is the best indicator of
general economic development. Furthermore, Goldsmith (1969) contends that
financial institution development is of prime importance for real economic
development because the financial superstructure in the form of both primary and
secondary securities accelerates economic growth and improves economic
performance to the extent that it facilitates the migration of funds to the best user.
This refers to the place in the economic system where the funds will yield the
highest social return.
The positive view of the finance-led growth hypothesis normally focuses
on the role played by financial development in mobilizing domestic savings and
investment through a more open and more liberalized financial system, and in
promoting productivity via creating an efficient financial market. Chen (2002) for
example, has examined the causal relationship between interest rates, savings and
income in the Chinese economy over the period 1952 to 1999 by using the
cointegration test and Bayesian vector autoregressions (BVAR) model. He argues
that it is therefore important to establish well-developed financial institutions-
particularly the independence of the Central Bank-interest rate liberalization and
7
sound financial intermediation, all of which are important for the efficient
allocation of capital, which, in turn, can help to establish sustainable economic
growth (Chen, 2002:59).
However, there are some literatures which provide empirical evidence
against the financial-led growth hypothesis. Al-Yousif (2002), for example, has
used both time series and panel data from 30 developing economies to examine
the causal relationship between financial development and economic growth. He
found that financial development and economic growth are mutually causal, that
is, causality is bi-directional.
More empirical evidence is found for the developing economies where no
causal relationship exits from financial development to economic growth. Using
Granger causality and cointegration approach for selected Arab countries, Al-
Tamimi, Al-Awad and Charif (2001) found that there is no clear evidence that
financial development affects or is affected by economic growth. Cargill and
Parker (2001) have discussed the dangers and consequences of financial
liberalization by using the experiences in Japan and provided summary of lessons
that Chinas reformers should learn from the recent financial experiences of their
Asian neighboring countries.
Openness and Economic Growth
The correlation between openness to international trade and both income and
growth in developing countries has triggered a lively debate as to whether
international trade causes better growth outcomes. On one side of the debate is
advocates of free trade such as Goyal (2006) who argue that countries perform
better with outward orientation than with import substitution. In addition, casual
observation seems to suggest that more or less outward-oriented economies with
few restrictions on international transactions have experienced a better economic
performance than inward-oriented economic with high tariff walls and strict
controls of capital movements (Gundlach, 1997).
On the other hand, those who take a more skeptical view of the evidence
on the relationship between trade and growth, most systematically expressed in
8
Rodriguez and Rodrik (2000). The skeptical view is that the quality of institutions
trumps anything else and that the integration has essentially no independent
effect on growth.
An endogenous problem traditionally hinders investigations of the effect
of trade on growth. Trade openness is likely to be in part caused by growth or by
other factors that may have a direct effect on growth such as the quality of
institutions (Romalis, 2006). Openness measures based on trade shares therefore
suffer from the likelihood that countries experiencing fast growth rates for reasons
other than trade may more rapidly expand their trade. Use of trade policy
measures does not overcome the problem, because countries that adopt more
liberal international trade policies may also adopt other market-friendly policies.
Cieslik and Monika (2008) mentions that in the open economy setting
varieties of the intermediate goods available in the follower economy are
produced by foreign, local and multinational firms. A local firm can invent a new
variety of goods or imitate products that are already known in the leader country.
It is assumed that it is cheaper for the follower country to imitate goods that exist
in the leader country because the imitation cost is smaller than the innovation cost.
Hence, in equilibrium, however, no firm decides to innovate in the follower
country. Local firms imitate foreign products and multinational firms adapt their
products to the local environment in the follower economy, both of which are
assumed to be cheaper than innovating.
Inflation and Economic Growth
Blancard (2006:191) explains in the medium-run,economic growth is
influenced by money growth and inflation as following equation:
t mt yt
g g t =
................................................................................... (1)
where yt
g
is economic growth, mt
g
is nominal money growth and t
t
is inflation.
If the nominal money growth is faster than inflation, the economic growth will be
increasing
( ) 0 > >
yt t mt
g g t
. In contrast, if the nominal money growth is
slower that inflation, the economic growth will be reduced
( ) 0 < <
yt t mt
g g t
.
9
In the long-run, Blancard (2006:191) also mentions that the nominal
money growth and economic growth will be equal
( )
y m
g g =
. Thus, the
relationship between the economic growth, the nominal money growth and
inflation is as following equation:
y m
m y
g g
or
g g
=
=
t
t
.. (2)
As a consequence, the inflation as well as the adjusted nominal money growth
will be equal with the nominal money growth reduced by the output growth in the
long-run.
IBFIs in Indonesia: A Brief Overview
Indonesia has the spectacular development on its Islamic banking since Bank
Muamalat, the first Islamic banking institution was established in 1992. In fact,
slowly but continually, the Islamic banking gives its contribution to the
Indonesian economic growth by serving the economic society according to
shariah principles, especially involving in interest prohibitions, non-speculative
activities and un-fair transaction (Ascaraya and Yumanita, 2005).
Islamic banking in Indonesia has been getting better especially when the
Indonesian government and central bank (Bank Indonesia) manage and decide to
give strong commitment through policies to build Islamic banking in Indonesia.
Seriously, the implementation of good willingness is started by amendment of
Islamic banking regulation, UU No. 7 1992 revised by UU No. 10 1998. All of
their policies are not only depending on the number of the offices and Islamic
banking operation for increasing supply sides but also developing the
understanding and awareness for increasing demand sides. Bank of Indonesia
allows the conventional banking to launch shariah division units (UUS).
Consequently, the numbers of Islamic banking offices are increasing in many
regions in Indonesia. This condition, therefore, gives the opportunity to Islamic
banking to be more developed.
10
According to Bank Indonesia at Indonesian Islamic Banking outlook 2010,
the development of Indonesian Islamic banking shows relatively high growth in
terms of business volume (26.55% y-o-y). Although the growth was relatively
lower than the previous year but it was higher than the conventional banks (12.5%
y-o-y). Therefore, generally, Islamic banking still has good performance of its
intermediary function compared to the conventional banks.
Figure 1
Islamic Banking Performance
Source: Bank Indonesia-Indonesian Islamic Banking outlook 2010
In addition, the performance of Islamic banks funding showed a
significant improvement although it ever recorded a downturn after the global
financial crisis. This can be shown at Figure 2 bellows.
Figure 2
Development of Islamic Banks Third Party Fund
Source: Bank Indonesia-Indonesian Islamic Banking outlook 2010
11
3. Methodology
Johansen-Juselius Cointegration Test
According to Haris (1995), a VAR-based approach of Johansen (1988) and
Johansen and Juselius (1990) can be used to test the cointegration. Roughly, the JJ
test for cointegration is based on evaluating the rank of coefficient matrix of level
variables in the regression of changes in a vector of variables on its own lags and
lagged level variables. The rank of the matrix, which depends on the number of its
characteristic roots (eigenvalue) that differ from zero, indicates the number of
cointegrating vectors governing the relationships among variables.
Ibrahim (2006) explains that Johansen (1988) and Johansen and Juselius
(1990) develop two test statistics to determine the number of cointegrating vectors
the trace and the maximal eigenvalue statistics:
) 1 ln(
) 1 ln(
1
1
+
+ =
=
=

r Max
i
k
r i
Trace
T
T


........................................................... (3)
Where T is the number of effective observations and

s are the estimated
eigenvalues. The trace statistics tests the null hypothesis that there are at most r
cointegrating vectors against a general alternative. Meanwhile, the maximal
eigenvalue test is based on the null hypothesis that the number of cointegrating
vectors is r against the alternative hypothesis that it is r + 1.
In a nutshell, the empirical method of the present study consists of the
following steps. First, we evaluate unit root and cointegration properties of the
variables. Then, we estimate a VAR model, from which we assess the causal
nexus among the variables concerned. More specifically, we simulate variance
decompositions and impulse response functions as a basis of causal indifferences.
Accordingly, the model used in this paper is a level VAR or it can be
called as VECM (Vector Error Correction Model). The VECM equations can be
derived as equation 4 and 5:
12
The 1
st
Model:
| |

run Long
t
t
t
t
t
OE CPI JII TD RY
OE
CPI
JII
TD
RY
run Shosrt
t
t
t
t
t
t
t
t
t
t
OE
CPI
JII
TD
RY
OE
CPI
JII
TD
RY
OE
CPI
JII
TD
RY
(
(
(
(
(
(

(
(
(
(
(
(

+
(
(
(
(
(
(

A
A
A
A
A
I =
A
A
A
A
A

1
1
1
1
1
1
1
1
1
1
| | | | |
o
o
o
o
o
.. (4)
The 2
nd
Model:
| |

run Long
t
t
t
t
t
OE CPI JII TF RY
OE
CPI
JII
TF
RY
run Shosrt
t
t
t
t
t
t
t
t
t
t
OE
CPI
JII
TF
RY
OE
CPI
JII
TF
RY
OE
CPI
JII
TF
RY
(
(
(
(
(
(

(
(
(
(
(
(

+
(
(
(
(
(
(

A
A
A
A
A
I =
A
A
A
A
A

1
1
1
1
1
1
1
1
1
1
| | | | |
o
o
o
o
o
(5)
where RY is real Gross Domestic Product (GDP); TD and TF are ratio of total
Islamic deposits and total Islamic financing, respectively, to nominal GDP; JII is
the moving-average of the standard deviation of the Jakarta Islamic Index; CPI is
the change of the Consumer Price Index; and OE is the ratio of total import and
exports to nominal GDP. The 1
st
model is for the evidence of total deposits and
the 2
nd
model is for total financing. This is because total deposits (TD) and total
financing (TF) are correlated each other, we separate these variables into different
model.,
ARDL Model
Karim, et al (2009) explain that while cointegration approaches such as
Engle and Granger (1987), Johansen (1988) and Johansen and Juselius (1990)
allow testing for the absence of a long-run relationship under the restrictive
assumption that all the systems variables are integrated of order one, the value
added of the bounds testing procedure is that it allows testing for cointegration
13
when it is not known with certainty whether the regressors are purely
( ) 0 I
, purely
( ) 1 I
or mutually cointegrated.
Thus, the conditional autoregressive distributed lag model (ARDL)
approach can be employed regardless of the stationarity properties of variables in
the samples and allows for inference on long-run estimates, which is not possible
under the alternative cointegration procedure. Pesaran and Shin (1995) mentioned
that the ARDL framework is consistent in small sizes. However, Narayan et al
(2004) noted that increasing the number of observations such as occupying high
frequency data does not create a robust cointegration results because what matters
is the length of the period rather than the number of observations.
The study therefore employs the ARDL bounds test proposed by Narayan
et al (2004) to investigate the cointegration relationship between Islamic banks
and economic growth. The ARDL procedure actually involves two stages. Those
are establishing a long run relationship among variables and estimating the long
and short run coefficients of equations conditional on whether the variables are
cointegrated (Karim, et al, 2009). Mathematically, according to Majid & Kassim
(2010), the ARDL models used in this paper are as below.
t t t t t t
t t t t t t
OE CPI JII TF RY Model
e OE CPI JII TD RY Model
| | | | |
o o o o o
+ + + + + =
+ + + + + =
4 3 2 1 0
4 3 2 1 0
: 2
: 1
.. (6)
Moreover, according to Narayan (2005) as well as Majid and Kassim
(2010), the error correction version of the ARDL models employed in this study
are as follows:
Equation (7)
t t t t t t
p
i
p
i
i t i
p
i
p
i
i t i
p
i
i t i i t i i t i t
t t t t t t
p
i
p
i
i t i
p
i
p
i
i t i
p
i
i t i i t i i t i t
u OE CPI JII TF RY
OE CPI JII TF RY RY
u OE CPI JII TD RY
OE CPI JII TD RY RY
1 1 5 1 4 1 3 1 2 1 1
1 0 0 0 0
0
1 1 5 1 4 1 3 1 2 1 1
1 0 0 0 0
0
+ + + + + +
A + A + A + A + A + = A
+ + + + + +
A + A + A + A + A + = A

= =

= =

=


= =

= =

=




| | c o

| | c o
14
where according to Majid and Kassim (2010) and Karim et al (2009), the
summation above represents Error correction dynamic; s

correspond to the long

run relationship; and
A
is the difference operator; t
c
is white noise error term.
Firstly, we estimate Equation (2) by Ordinary Least Square (OLS)
technique. The above model is based on the assumption that the error term is
serially uncorrelated. Thus, it is important that the lag order p of the underlying
model is chosen appropriately (Karim, et al, 2009). Thus, we use appropriate lag
length based on Akaike Information Criterion (AIC) with no serial correlation in
the model.
Secondly, we implement the bound testing procedure. The bound test used
for examining evidence for a long run relationship can be conducted by using the
standard Wald or F statistics. The F test has a non-standard distribution which
depends upon: a) whether variables in the ARDL model are I(0) or I(1); b) the
number of regressor; c) whether the ARDL model contains an intercept and/or a
trend; and d) the sample size.
Two sets of critical values are reported in Pesaran et al. (1997). The two
sets of critical values provide critical value (CV) bounds for all classifications of
the regressors into purely I(1), purely I(0) or mutually cointegrated. However,
these CVs are generated for sample sizes of 500 and 1,000 observations and
20,000 and 40,000 replications respectively. Narayan (2005) argues that existing
CVs because they are based on large sample sizes, cannot be used for small
sample sizes.
Given the relatively small sample size in the present study (31
observations) critical values are calculated specific to the sample size. As an
additional contribution to the literature, critical values for sample sizes ranging
from 30-80 observations are calculated and reported in the Narayans appendix. If
the computed F statistics is higher than the upper bound of the critical values then
the null hypothesis of no cointegration is rejected.
Therefore, the null of no cointegration in the long run relationship is
defined by
0 :
5 4 3 2 1 0
= = = = = H
is tested against the alternative
15
of
0 :
5 4 3 2 1 0
= = = = = H
, by the means of familiar F-test. Furthermore,
the asymptotic distribution of the F-statistic is non-standard under the null
hypothesis of no cointegrating relation between the examined variables,
irrespective of whether the explanatory variables are purely I(0) or I(1) (Halim, et
al, 2008).
In the next stage, we estimate the variance decompositions (VDCs) which
is enable us to measure the percentage of the forecast error of variable that is
explained by another variable (Majid and Kassim, 2010). Furthermore, Hoffman
and Rasche (1997) noted that the equation model for Vector Error Correction
Model (VECM) framework is as follows:
t k t k t k t i t
Z Z Z Z c o + H + I + + I + = A

......
1 .. (8)
where ( ) o ; , , , / , OE CPI JII TD TF RY Z
t
= is an nx1 vector of constant;
I
is an n x
n matrix (coefficients of the short run dynamics);
' o| = H
where
o
is an n x 1
column vector; and t
c
is an n x 1 vector of white noise error term and k is the
order of autoregression.
4. Empirical Results
4.1 Data
In assessing the contribution of Islamic banks on Indonesian economic growth,
this study utilizes the real GDP (RY) as a measure for economic growth; the ratio
of total Islamic deposits (TD) and the ratio of total Islamic financing (TF)
respectively to nominal Gross Domestic Product (GDP) as measures for Islamic
banking intermediarys development; the moving-average of the standard
deviation of the Jakarta Islamic Index (FV) as a measure of the volatility of the
Islamic financial institutions; the change in the Consumer Price Index (INF) as a
measure for prices; and the ratio of total imports and exports to nominal GDP
(OE) as a measure of openness of the economy. The data span used in this study is
from 2002.Q4 to 2010.Q2. Data were collected from Bank Indonesias Monthly
Statistical Bulletin (various issues) and IMFs International Financial Statistics,
CD-Room version, and Bloomberg.
16
4.2 Unit Root Test
While the bounds test for cointegration does not depend on pre-testing the order
of integration, all variables needs to be integrated of order one (Narayan, 2005).
To ascertain the order of integration, the work begins through applying the
Augmented Dickey Fuller (ADF) unit root tests.
According to Gujarati (2003:817) the ADF unit root test can be presented
as follows:

=
+
+ A + + = A
p
i
t i t i t t
Y Y Y
1
1 1 0
c | o
....................................................... (9)
Where Y
t
is the first difference type of data,
0
is the intercept, Y is the variable
that tested the stationary, p is lag length, and is the error term.
The hypothesis test (H
o
and H
1
) is done by comparing the result of ADF
test
satistik
to t statistic of Mackinnon critical value 1%, 5%, 10%. If the result of
ADF
test statistik
is less than Mackinnon critical value, H
o
will be received and H
1
will
be rejected. It means the data is not stationary, vice versa. If all of data are not
stationary on the level, differencing data will be done by reducing the data with its
previous to get the first or second difference.
Actually the ADF suggests that [I, S] are each integrated of order one or
I(1). The results of the test which is utilized in trend and intercept and lag 7 are
presented in Table 1.
Table 1
ADF Unit Root Test
X X
RY -1.841261 -7.085805
[-2.621007] [-3.679322]***
TD 3.085828 -7.935213
[-2.627420] [-3.679322]***
TF -0.328916 -3.444581
[-3.218382] [-3.229230]*
JII -1.544243 -4.377652
[-2.622989] [-3.699871]***
CPI -2.534006 -7.368653
[-2.621007] [-3.679322]***
OE -1.719104 -4.807182
[-2.621007] [-3.679322]***
Note: ***,**,and * denote significance at
1%, 5% and 10% levels respectively
Variable
ADF Test
17
RY -3.49 8126 -6.91 6768 [-3.21 8382]* TD 1.69 778 -4.62 9833 [-3.22 9230] [-4.339 330]*** TF -0.18 0246 -3.44 4581 [-3.22 9230] [-3.22 9230]* FV -3.03 8714 -2.68 5549 [-3.22 1728] [-1.964 418]** INF -5.55 9034 -3.26 2827 [-4.296 729]*** [-3.22 9230]* OE 0.56 3118 -4.19 0407 [-3.23 8054] [-3.603 202]** Not e:*,**,a nd***d enotesi gnifican ceat Variabl e A DFTes t
As may be observed from the Table 1, the ADF test indicates that all variables are
non-stationary in level although they have been stationary in the different level.
However, all variables are already stationary in the first different. Thus, these data
are applicable to be treated by Johansen-Juselius cointegration test.
4.3 Cointegration Test
Johansen-Juselius
Given results of the unit root test, we proceed to Johansen-Juselius cointegration
test on lag 2 and the results of the cointegration test are given in Table 2:
Table 2a
Johansen-Juselius Cointegration Test for Model 1
Null Hypothesis
Test Statistic Critical Value 5%
Trace Max Trace Max
r = 0 81.91* 34.12* 69.82 33.46
r 1 47.77 26 47.85 27.07
r 2 21.76 11.38 29.79 20.97
r 3 10.38 7.4 15.49 14.07
Note: ***, **, and * denotes significantly at 1%, 5% and 10% level of significance,
respectively
From the test we find evidence of cointegration among the variables based on the
trace statistics and Max Eigen value in the 1
st
and 2
nd
model.
Table 2b
Johansen-Juselius Cointegration Test for Model 2
Null Hypothesis
Test Statistic Critical Value 5%
Trace Max Trace Max
r = 0 97.04* 47.95* 69.82 33.87
r 1 49.99* 24.16 47.86 27.58
r 2 25.84 14.5 29.79 2.23
r 3 11.33 6.41 15.49 14.26
Note: ***, **, and * denotes significantly at 1%, 5% and 10% level of significance,
respectively
18
More specifically, the test suggests that there is at least one cointegration or long
run relationship among variables.
ARDL Bound Test
The cointegration test under the bounds framework involves the comparison of
the F-statistics against the critical values, which are generated for specific sample
sizes. This test actually is sensitive to the number of lags used for each variable
(Bahmani-Oskooee and Brooks, 1999). In this study lags up to three periods have
been imposed on each variable. The calculated F-statistics for RY, TD/TF, FV,
INF and OE of models 1 and 2 are reported in Table 3.
Table 3
ARDL Approach to Cointegration: Result of F-Test
M odel 1 M odel 2
Tot al Depos i t Tot al F i nan c i n g
1 2. 223 2. 67
2 3. 047* 3 . 479**
3 4. 696* ** 8. 082** *
I(0) I(1)
1% 4. 59 6. 368
5% 3. 276 4. 63
10% 2. 696 3. 898
Co m put ed F -S t at i s t i c
Lag O rder
Cri t i c al V al u e: Int erc ept and No Trend
No t e : * ,* * , a n d * * * d e n o t e s s ig n ific a n t ly a t 10% ,
5% a n d 1% le v e l o f s ig n ific a n c e , re s p e c t iv e ly
Cointengration among economic growth, TD, JII, CPI and OE in Model 1
exits when economic growth is the dependent variable because it is at least one F-
value that is higher than the upper critical value (Afzal, et al., 2010). The null
hypothesis of no cointegration among economic growth, TF, JII, CPI and OE is
also rejected in Model 2 because at least one F-value is higher than the upper
critical bounds value. Therefore, cointegration found among the variables was
established and then Models 1 and 2 were estimated by using ARDL approach.
19
4.4 Long-run and Short-run Elasticity
To assess Models 1 and 2, concerning the effect of TD/TF, JII, CPI and OE on
economic growth, we estimate Equation 6 by using ARDL approach. Prior to
estimate the short-run and long-run relationship between economic growth and the
independent variables, i.e. TD/TF, JII, CPI and OE, we have to determine the lag-
length on the first difference variables (Karim, et al., 2009). The order of the
distributed lag on the dependent variable and the regressors is selected using
Akaike Information Criterion (AIC). Based on AIC, the optimal lag length chosen
is three.
Following the establishment of the existence of cointegration, we retain
the lagged level of variables and estimate the Equation 1 based on the ARDL
model. The long-run coefficient estimates or, in the other words, the results of
dynamic ARDL (0,1,2,0,3) for Model 1 and (0,3,2,0,3) for Model 2 are reported
in Table 4 while the estimates of the error correction model (ECM), the short run
coefficients, are presented in Table 5.
Table 4
ARDL (0,1,2,0,3) for Model 1 and ARDL (0,3,2,0,3) for Model 2 Based on
(AIC) (Dependent Variable: RY)
Coefficient Prob Coefficient Prob
TD 0.042495 [0.791] - -
TF - - 0.048623** [0.031]
JII 0.4776E-3*** [0.006] 0.2319E-3 [0.178]
CPI -0.005785*** [0.000] -0.00575*** [0.000]
OE 0.0044511*** [0.001] 0.0266* [0.076]
C 13.5608*** [0.000] 13.522*** [0.000]
Diagnostic
Statistics DW-stat = 2.37
Note: *,**, and *** denotes significantly at 10%, 5%and 1%level of significance,
respectively
Regressor
Model 1 Model 2
ARDL [0,1,2,0,3] ARDL [0,3,2,0,3]
R2 = 0.99503
DW-stat = 2.35
R2 = 0.99593
Co efficient T-Rat ioCo efficient T-Ratio TD -0 .024160 -1.425 7 - - TF - - 0.0 40659* 2.543 1 FV -0.0 065451** -4.321 8-0.00 71866*** -6.054 9 INF -0.0 032296*** -6.633 6-0.0 036138* -7.681 0 OE -.0 012038 -0.935 6-0.7 215E-3 -0.860 9 C 2 .9955** 5.678 53. 6100*** 6.648 0 Diag nostic Stati stics Note :*and**d enotessigni ficantlyat5 %and1%l evelofsigni ficance,resp ectively R2=0 .99994 R2=0 .99992 Regressor Mod el1 Mod el2
We use ECM to confirm the existence of a stable long-run relationship and
cointegration relationship among variables. From Table 4, the results indicate that
20
total deposit does not have a long-run impact on economic growth. In contrast,
model 2 shows that total financing seems to have a long-run effect to economic
growth while other variables, except Jakarta Islamic Index in model 2 has a long-
run impact on economic growth.
These results have been contradicted with the findings of Karim, et al.,
(2009) indicating that both total deposit and total financing of Islamic banks in
Malaysia have a long-run impact on economic growth. This may be because the
Malaysian Islamic banks were too much established earlier than Indonesian
Islamic banks. Therefore, its effect to national economy is higher than in
Indonesia. Nevertheless, the Jakarta Islamic Index and inflation in Indonesia as
well as in Malaysia has a long-run impact on economic growth.
Table 5 shows that the coefficient of the ECM in model 1 and 2 is negative
and highly significant at 1%. This confirms the existence of a stable long-run
relationship and indicates to among variables (Odhiambo, 2008). According to
Karim, et al., (2009), the coefficient of the ECM is -1.000 in Model 1 and -1.000
in Model 2 implies that a deviation from the long-run equilibrium following short-
run disturbances is corrected by about 19.6 percent after one quarter in Model 1
and 22.48% in Model 2.
Table 5
Error Correction Representation using the ARDL (0,1,2,0,3) for Model 1 and
ARDL (0,3,2,0,3) for Model 2 Based on AIC
(Dependent Variable: RY)
Coefficient Prob Coefficient Prob
TD -0.0035 [0.791] - -
TF - - -0.0486 [0.203]
JII -.04776E-3*** [0.006] -0.2319E-3 [0.176]
CPI -0.00578*** [0.000] -0.0057*** [0.000]
OE -0.00445*** [0.001] -0.00266* [0.074]
Constant 13.5608*** [0.000] 13.5329*** [0.000]
ECMt-1 -1.000*** [0.000] -1.000*** [0.000]
Diagnostic
Statistics
Model 2
ARDL [0,1,2,0,3] ARDL [0,3,2,0,3]
Regressor
Model 1
R2 = 0.99994
DW-stat = 2.35
Note: *,**, and *** denotes significantly at 10%, 5% and 1% level of significance,
respectively
R2 = 0.99002
DW-stat = 2.37
21
The ECMs correspond to the speed of adjustment to restore equilibrium in the
dynamic model of following disturbances. The performances of our estimated of
the error correction representation for ARDL seem to be acceptable especially
when the Adjusted R
2
value is relatively high. In addition, the diagnostic tests
perform well, supporting the overall validity of the short-run model.
In Indonesia, accordingly the ratio of total imports and exports has a long-
run and short-run effect on economic growth. This is because the probability in
both long run and short run analysis are significant.
4.5 Variance Decompositions and Impulse Responses of VECM
Because according to Johansen and Juselius both models have the cointegration,
thus the VECM system consisting is estimated. The lag order of VECM is chosen
from the FPE, AIC, SC and HQ. From the estimated VECM, we simulate variance
decompositions and impulse response functions.
Table 6 presents variance decompositions at various horizons of each
variable. Meanwhile figure 2 and 3 graph the response of economic growth to
other variables in the system.
Table 6
Variance Decomposition of Economic Growth (RY) in Models 1 and 2
RY TD/TF JII CPI OE
1 100.00 - - - -
4 92.08 0.53 3.51 2.87 0.99
8 93.98 0.49 2.18 2.53 0.82
12 94.95 0.44 1.57 2.20 0.84
16 95.46 0.44 1.23 2.02 0.85
20 95.79 0.44 1.02 1.88 0.87
1 100.00 - - - -
4 93.12 0.32 4.10 2.24 0.23
8 93.70 0.43 4.22 1.49 0.15
12 91.90 0.94 6.06 0.97 0.12
16 89.08 1.57 8.60 0.65 0.11
20 85.50 2.31 11.63 0.46 0.10
Explained by variations in
Model 1: Total Deposit (TD)
Horizon
Model 2: Total Financing (TF)
22
Various interesting results may be observed from the variance
decompositions, but this study is only focused on the interaction between
economic growth and other variables, i.e. TD/TF, JII, CPI and OE. Regarding to
those results, in Model 1 we find evidence the insignificant role of RY in
accounting for variations in TD. More specifically, TD forecast error variance is
attributable to innovations in RY 0.53% at 4-quarter, 0.49% at 8-quarter and this
contribution is decreasing gradually until 0.44% at 20-quarter horizons. The
result, thus, shows that TD is not too much influencing to RY. Nevertheless, the
Jakarta Islamic Index and inflation have more but not adequate significant role of
economic growth. This finding thus is consistent with the ARDL model showing
that JII has a long-run effect on economic growth in Model 1, but not in model 2.
This is because the JII forecast error variance is only contributing to innovations
in economic growth by 3.51% at 4-quarter and decreasing gradually to 1.02% at
20-quarter horizons. Moreover, the CPI forecast error variance is contributing to
innovations in economic growth by 2.87% at 4-quarter although its effect is
decreasing gradually until 1.88% at 20-quarter horizons.
While model 1 show that total deposits do not have a significant
contribution on economic growth, model 2 of variance decomposition indicates
that total financing have an adequate impact on economic growth. This is because
the TF forecast error variance is contributing to innovations in economic growth
by 0.32% at 4-quarter horizons and increasing sharply to 2.31% at 20-quarter
horizons.
The response function of economic growth to TD, JII, CPI and OE has
been plotted in Figure 2, further substantiates this observation. Note that there are
insignificant responses of economic growth to TD and OE innovations since the
first quarter until 20-quarter horizons. Since Figure 2 also provides that economic
growth tends to increase in responses to innovations in TD, Islamic banks in
Indonesia must continue their efforts to increase their contribution on the national
economy.
23
Figure 3
Impulse Response Functions of Model 1
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to RY
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to TD
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to OE
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to JII
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to CPI
Response to Cholesky One S.D. Innovations
The response function of economic growth to TF, JII, CPI and OE has
been plotted in Figure 3. Note that there is an adequate significant response of
economic growth to TF especially after 12-quarter horizons. Since the economic
growth seems to be increasing in responses to innovations in TF, Islamic banks in
Indonesia must continue their efforts to increase their contribution on the national
economy.
24
Figure 4
Impulse Response Functions of Model 2
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to RY
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to TF
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to OE
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to JII
-.10
-.05
.00
.05
.10
.15
.20
.25
2 4 6 8 10 12 14 16 18 20
Response of RY to CPI
Response to Cholesky One S.D. Innovations
5. Conclusion and Policy Implication
This study examines the contribution of IBFIs on Indonesian economic growth.
From ARDL bound testing approach it can be asserted that total deposits has not a
long-run impact on economic growth; however, total financing shows the opposite
result. This evidence indicates that savings through Islamic banks do not
contribute yet to economic growth. Since the economic growth tends to be
increasing in responses to innovations of total deposits, Islamic banks have to
continue to increase their funding. When Bank Indonesia claims that the growth
of the third party fund was significantly affected by the competitiveness of the
returns offered by Islamic banks, they must keep their return to be competitive
25
compared the conventional banks especially on the long-term deposits which have
been dominated on Islamic banks funds.
Figure 5
Proportion of Islamic Banking Portfolio
Source: Bank Indonesia-Indonesian Islamic Banking outlook 2010
Different with Malaysian evidence, total financing in Indonesia has been
still not much contributing on economic growth rather than the moving-average of
the standard deviation of the Jakarta Islamic Index and inflation. When economic
growth is increasing in responses on shocks of the moving-average of the standard
deviation of the Jakarta Islamic Index, Islamic capital market has the opportunities
to be developed. Furthermore, when economic growth is decreasing in responses
on innovations of inflation, Bank Indonesia must keep the inflation to be stable
and at lower level through its inflation targeting policy.
However, the economic growth could be rising in responses to total
financing. If Malaysia with the longer establishment of its IBFIs can make its
Islamic banking and finance industry has been one of the relevant policy options
to further promote economic growth, Indonesia optimistically would come
afterward in its IBFI. Furthermore, Indonesian IBFIs in future could duplicate the
prestige of Malaysian IBFIs in term of supporting the economic growth in the
country. Therefore, continuous efforts should be undertaken to promote the
development of the IBFIs due to its adequate contribution to Indonesias
economic growth. Similarly with the argument of Majid and Salina Kassim
26
(2010), improving the financial infrastructure as well as increasing the pool of
human capital to cater for higher demand for human capital in the Islamic banking
industry in the future is necessary to increase the contribution of IBFIs on
Indonesian economic growth.
6. Limitation of the Study and Suggestion for Future Research
There are some limitations to this study that need to be highlighted. This study has
been addressed to analyze the contribution of IBFIs to the Indonesian economic
growth in period of 2004.Q4 to 2010.Q2. In fact, share of Islamic banking until
2010.Q2 is only 3 percent from total share of national banking industry. By using
the simple statistics, it might be known that the contribution of IBFIs to the
economic growth is still small. Econometrics is the only tool for testing the
economic phenomena. The truth of the econometrics justification must be
analyzed by using the economic logic as well. However, this study gives
advantages for future research in order to modeling the impact of IBFIs to
Indonesian economic growth using ARDL and VECM approach.
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