Causality between financial development and economic growth, and the Islamic finance imperative: A case study of Indonesia

Indonesia has been rapidly showing signs of advanced economic development. The country’s central bank is of the view that with the unbanked accounting for more than half of the population, the potential for growth in the world’s biggest Muslim population is immense. This article makes an attempt to test the possible directions of causality between financial development and economic growth, with Indonesia as a case study. It also discusses the results in the context of the development of Islamic finance in Indonesia. The study is conducted by applying the Autoregressive Distributed Lag model (ARDL) analysis (also known as the Bounds testing procedure) proposed by Pesaran et al. (2001). This article is believed to be one of the first to extend the finance-growth nexus discussion to include the development of Islamic finance. The study finds a unique cointegrating relationship among GDP per capita, gross fixed capital formation, annual population growth rate, and domestic credit to private sector. These findings have clear policy implications in that a policy of development and growth of the financial sector will help enhance economic growth, and will provide the necessary base from which Indonesia can significantly enhance its Islamic finance industry