CAN ISLAMIC FINANCE DRIVES ECONOMIC GROWTH? : EMPIRICAL EVIDENCE FROM INDONESIA

The purpose of this paper is to analyze the contribution of Islamic finance to Indonesian economic growth in view Global Islamic Finance Report which places Indonesia as number 1 globally in terms of Islamic Finance Country Index for the year 2019. Using quarterly dataset (2013:1-2018:4), this paper study employs ARDL framework and bounds testing approach to co-integration to investigate the influence of Islamic finance on Indonesian economic growth. The results show that in the long run Islamic finance is positive and significantly correlated with economic growth of Indonesia. The result obtained from Error correction model reveal a positive and significant long run causal effect of Islamic finance on Indonesian's economic growth. However, Indonesian Islamic capital market is found not to have a significant long run causal effect on the country's economic growth.


Introduction
An economic system requires harmony and balance between sectors, such as the real and financial sectors. The real sector needs funds from the financial sector as a source of financing in the framework of the production process. Vice versa, the financial sector needs the real sector as a medium to invest in available funds (Hadi, 2015). Strong evidence of the growing popularity of Islamic financial products and instruments after the crisis global financial market. The increasing demand for Islamic financial products and investments including Islamic bonds, Islamic stock market, exchange-traded Islamic mutual funds, Islamic insurance (takaful) is evidence that supports the growing popularity of Islamic financial markets. In the last two decades, the Islamic finance industry globally has shown quite rapid development. In recent years there has been significant growth in the Islamic financial industry, especially in the Middle East and Southeast Asian countries that grew after the 2008-2009 global financial crisis (GFC). The total amount of sharia financial assets managed is estimated at US $ 1.6 trillion at the end of 2012 and US $ 1.8 trillion at the end of 2013, touching US $ 2.1 trillion at the end of 2014 and estimated at US $ 6.5 trillion in the year 2020. (Hammoudeh, Mensi, Reboredo, & Nguyen, 2014).
Likewise, Indonesia continues to strive to develop Islamic finance. The development of the Islamic financial industry shows a significant development in the global arena. This can be seen from the publication of the Global Islamic Finance Report which places Indonesia at number 1 of the Islamic Finance Country Index for 2019 (Global Islamic Finance Report, 2019). In recent years, the relationship between financial development and economic growth has been the main subject in the field of economic development (Grassa & Gazdar, 2014). Economists have been interested in the role of financial institution expansion in allocating resources to economic growth. Some researchers agree that the importance of the role of the financial sector in increasing real growth, both at national and international levels (Zarrouk, El Ghak, & Abu Al Haija, 2017). The theoretical foundation of this relationship can be traced from the work of Joseph Schumpeter in the early twentieth century, King and Levine (1993) as well as Levine, (1997) who show the important role played by the financial sector via directing financial resources to the deficit sectors and thereby contributing to the recall of productivity and economic growth. Islamic banking plays at least four important roles: encouraging loans, stimulating savings, increasing financial stability, and contributing to financing based on Islamic principles. Islamic finance is Budi Trianto, Masrizal, Tasiu Tijjani Sabiu. Can Islamic Finance Drives Economic Growth?: Empirical Evidence from Indonesia 143 considered a stable financing system and can encourage growth and create long-term employment (Boukhatem & Ben Moussa, 2018).
The interest in the issue of Islamic banking and finance is not only due to rapid growth but is based on recurring financial crises over the last decade with the global crisis in 2007-2009 so severe. total sharia-managed financial assets are estimated at US $ 1.6 trillion at the end of 2012 and US $ 1.8 trillion at the end of 2013, reaching US $ 2.1 trillion at the end of 2014 and estimated at US $ 6.5 trillion by 2020 At present, the Islamic financial sector is no longer a business entity that is only operated to fulfill religious obligations, but it is a necessity.
Motivated by the resilience of Islamic finance during the crisis and rapid development in recent years, the researchers focused their studies on comparative analysis of Islamic and conventional banks, risk/stability, efficiency, and financing. The increasing growth of Islamic financial assets globally raises the question of whether Islamic finance has a role in global financial intermediation. Naqvi, Rizvi, Uqaili and Chaudhry (2018) examines whether Islamic banks can contribute to global financial re-intermediation? Providing answers that using data from 486 conventional banks and 154 Islamic banks from 21 countries shows that Islamic banks have a high intermediation ratio compared to conventional banks for the entire sample period and among the CAMELS variables, asset growth and bank loans, loan to deposit and loan ratios as the ratio of total productive assets. Imam and Kpodar (2016) in their research addressed whether the development of Islamic banking is good for economic growth. Using from 52 countries with data covering the period 1990-2010, the results illustrate that although its size is relatively small compared to the economy and the overall size of the financial system; Islamic banking is positively related to economic growth. Islamic banking supports economic growth through two main channels namely capital accumulation and increased financial inclusion with greater access to deposits. Islamic banking, which is one of the fastest-growing global financial segments, has unique features. Specifically based on the distribution of risks that make activities more closely related to the real economy. Thus, there is great uncertainty about the impact of the growth of Islamic banking. For this reason, further research is recommended because Islamic banks have much larger diffusion by looking at developments at the local level.
Indonesia has the largest Muslim population in the world, and Islamic banking has gained a great appeal with Indonesian banks highlighting 65% growth in Islamic banking assets over the past five years (Rizvi, Narayan, Sakti, & Syarifuddin, 2019 Some of them identified positive correlative results and some identified doubtful results. Important studies from this study also try to prove the relationship between financial development and economic growth. Some find a one-way relationship (unidirectional causality), some researchers also prove the existence of a two-way relationship (bi-directional causality). But there are also some studies that show that there is no causal relationship between financial development and economic growth. It is well recognized, that financial markets are very important for economic growth because they encourage the mobilization of unemployed deposits and turn them into useful and productive capital. However, when the economy grows, it will produce a surplus which triggers the growth of the financial sector.
Thus the direction of causality between financial development and economic growth is ambiguous and open for further investigation.
Beck and Levine (2004)   shows a long-term stochastic trend with the real economy and a small but negative influence on the real economy. Furthermore, Toda Yamamoto's approach is used to test financial growth empirically. The demand-driven hypothesis is only supported on the Shenzhen B stock market. The Shenzhen B stock market and the real economy support the view that any economic growth will affect the financial markets, which represent a causal relationship between growth in real economic output and stock market growth.
An incompatible relationship can be found from Gregorio and Guidotti's (1992) research finding a negative and significant impact on financial development on growth for Latin American countries. Favara (2013) (Zarrouk et. al., 2017). This is supported by Grassa and Gazdar (2014)   Lag test (ARDL) shows the results that a significant relationship in the short and long term period between the development of Islamic finance and economic growth and has a bidirectional relationship.
Furqani and Mulyany (2009) From the empirical studies above, statistical bias can occur due to variable problems.
For a small open economy like Indonesia, the external sector plays an important role. In addition, macroeconomic stability is likely to influence the development of the Islamic financial sector and real economic activity. Thus this study aims to look at the effect of Islamic financial development on Indonesia's real sector by including the external sector as other determining variables such as inflation and gross fixed capital formation.

Estimating Model
Applying the right methodology for time series data is the most important part of time series analysis so as not to provide biased and unreliable models or estimates. In this study, the short-term and long-term dynamic relationship between Islamic finance and growth uses the ARDL approach as presented by Pesaran, Shin, & Smith, (2001) which can be applied regardless of whether all variables are I (0), I (1), or are usually coordinated. Here we estimate the ARDL model : Where GDP is the real output at time t, FN is total Islamic banking financing, JII is the capitalization of the Jakarta Islamic index, TRADE is the volume of trade as a percentage of GDP and INF is inflation.
Where ECM is an error correction term. However, cointegration only implies a causal relationship but does not indicate its direction.

Unit Root Test Results
Although the ARDL approach can be applied to integrated variables of order zero or one representing I(0) or I(1) respectively. Stationary tests are needed to verify that none of variables are integrated of order two or I (2). Unit root test employing Augmented Dicker Fuller (ADF) and Philips Peron (PP) tests were executed based on constant and trend.
Considering both unit root test results of ADF and PP, table 1 below shows a mixture of variables stationary at level and first difference. In addition, the variables lnGDP, lnFN, JII, lnGFC, lnTRADE, INF are not integrated of order two or I (2). This permits applying of ARDL approach to co-integration. The Co-integration test result in table 2 below shows that the F-statistic value is greater than the upper critical value at 1%. and 5% based on unrestricted intercept and no trend.
The null hypothesis of no co integration is rejected. This indicate an evidence of the longrun co-movement between the variables exhibiting the propensity to proceed together in the long run.

Estimates of Long-run Relationship
Following evidence of long run co-integration or association among gross domestic product, Islamic bank financing, Islamic capital market, gross fixed capital formation and trade, the next stage is to estimate long run coefficient among the variables. The ARDL long run coefficients showcase the nature of the relationship among GDP and the regressors employed in the model. Result estimates of the long run relationship in Table 4 show a positive relationship among gross domestic product and Islamic bank financing. The result indicates that any 1% increase in Islamic bank financing will result to 0.43% increase in economic growth. Thus, financial intermediation is guaranteed to make a positive contribution to economic growth in Indonesia and this is in line with Naqvi, Rizvi, Uqaili and Chaudhry (2018). The positive contribution of Islamic finance to economic growth is also consistent with Abd. Majid and Kassim (2015), Chowdhury (2012), Abduh andOmar (2012), Furqani andMulyany (2009), Kassim (2016), Lebdaoui and Wild (2016), Mohd. Yusof and Bahlous (2013), Sabiu and Abduh (2020) as well as Zarrouk et al., ( 2017), but not supported with the findings Hachicha and Ben Amar, (2015) as well as Goaied and Sassi (2010). While JII as an indicator of the Islamic capital market does not drive significant on economic growth, it is in line with findings Carp, (2012)   Note: Significant at: *10, * *5 and * * *1 percent levels

ECM Long run Causality
Having found longrun cointegration among GDP, Islamic bank financing, Islamic capital market, trade and inflation as well as the long run coefficients, the next step entails determining if the model converge to long run equilibrium following shocks in the short run.
The error correction term in table 5 is negative and statistically significant which shows a proof of feedback effect or convergence to long run equilibrium and also an indication a long run causality in at least one direction. The overall ECM coefficient suggests that previous deviation from long run equilibrium is corrected at the speed of 111.5% .The result in table 5 reveals that Islamic bank financing (LNFN) has a significant positive long run effect on economic growth (GDP). Therefore, a 1% increase in Islamic bank financing will lead to increase in Indonesian economic growth by 0.0065%. The findings of positive long run causal effect is consistent with the work of Abduh and Omar (2012) in Indonesia, as well as Farahani and Dastan (2013) for nine Islamic countries including Indonesia.

Diagnostics Tests
Diagnostic test on the ECM were conducted to verify the competency of the model. Table 5 show that Glejser test indicate no econometric problem of heteroskedasticity. Also, Jarque Bera normality test reveals that the errors in the model are normally distributed.  Finally, regression estimates stability is tested using cumulative sum of squares (CUSUMSQ) and its test value in figure 1 appears stable as the regressed line falls within the critical bounds at 5% significance level. Thus, the variance estimates of the error correction model is satisfactory as it remains constant and stable over time. Therefore, ARDL model estimated in the study is robust in gauging the link between Islamic finance and economic growth in Indonesia.

Conclusions
The increasing proportion of assets that highlights 65% growth over the past five years makes a great attraction expected to play a role in improving the Indonesian economy. This study looks at the role of Islamic finance in the economy using the ARDL technique and the boundary testing approach for cointegration. The results of this study indicate that Islamic bank financing provides a significant contribution to economic growth. The existence of Islamic banking in the national banking system in Indonesia can drive the development of the national economy. The contribution of Islamic finance in the economy is made possible by the Islamic principles adopted in the operation of Islamic banks namely the prohibition of interest. Interest is one of usury practices. Interest is positively correlated with supply of investment funds, but it negatively correlated with demand for funds (credit or investment).
If interest rises, it will increase the supply of funds (savings) and decrease the demand of funds.
The decrease in demand of funds means a decline in investment, so it will be a negative impact on the economy namely economic growth decrease. On the other hand, profit sharing has a positive impact on economic growth. The principle of profit-sharing applied by Islamic banking is an indicator for increasing the economic output. Profit-sharing will increase