Journal of Islamic Accounting and Business Research

Financial development, Islamic finance and economic growth: evidence of the

UAE
Hajer Zarrouk, Teheni El Ghak, Elias Abu Al Haija,
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JIABR
8,1
Financial development, Islamic
finance and economic growth:
evidence of the UAE
2 Hajer Zarrouk
Emirates College of Technology, Abu Dhabi, UAE and
Received 22 May 2015 PS2D, Faculty of Economics Sciences and Management,
Revised 2 October 2015
24 November 2015 University Tunis El Manar, Tunis, Tunisia
6 January 2016
Accepted 6 January 2016 Teheni El Ghak
Faculty of Economic Sciences and Management of Tunis,
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University of Tunis El Manar, Tunis, Tunisia, and

Elias Abu Al Haija
Department of Banking and Finance, Emirates College of Technology,
Abu Dhabi, UAE

Abstract
Purpose – Does Islamic finance affect economic growth? The empirical literature in this area seems to
be in 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

Journal of Islamic Accounting and

Business Research
Vol. 8 No. 1, 2017
The authors would like to thank participants at The 2015 An Islamic Perspective of Accounting,
pp. 2-22 Finance, Economics and Management (IPAFEM) conference, University of Glasgow, UK, for their
© Emerald Publishing Limited
1759-0817
comments and suggestions. The authors specially thank Dr Mohamed Sherif. The authors take
DOI 10.1108/JIABR-05-2015-0020 responsibility for any errors in the article.
 vision in 2013 to become the “capital of the Islamic economy”, this study analyzed the finance, Islamic Islamic finance
finance and growth relations over the period 2013-2022.
and economic
Keywords Islamic finance, Data envelopment analysis, Growth, Financial development, UAE,
bVAR growth
Paper type Research paper

1. Introduction 3
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
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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,
 JIABR focusing on the UAE economy in this study is significant. Second, previous studies generally
8,1 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
4 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
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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.
 Islamic finance
and economic
growth

5
Figure 1.
Financial sector and
economic growth:
transmission channels
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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
 JIABR that a well-functioning financial system improves corporate governance by economizing on
8,1 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.
6 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
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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 Islamic finance
financial development – economic growth nexus. and economic
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
growth
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 7
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.
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3. Data and methodology

3.1 Data
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.

Variables Description Notation Source

Level of economic GDP per capita. Data are in constant R_GDP World Bank’s World Development
development 2005 local currency Indicators
Financial Money and quasi-money (M2) as a M2
deepening percentage of GDP
Degree of financial Domestic credit provided by T_Credit
intermediation financial sector as a percentage of
GDP
Degree of bank Domestic credit to private sector P_Credit Financial Development and Structure
development provided by banks as a percentage Dataset (2013)
of GDP Beck et al. (2000)
Islamic bank Total Islamic financial investment as Is_Invest IBIS data base Table I.
development a percentage of GDP Variables description
 JIABR 3.2 Methodology
8,1 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
8 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
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the constraint of the partial indicators availability[2]. The DEA model is thus the following:

Max 兺 v X ⫽ CI
i
i i0 0

ST: 兺 ␷ Y ⫽ 1 r r0
r

兺v X
i
i ij ⫺ 兺 ␷ Y ⱕ 0 ∀j ⫽ 1…
r
r rj …N Normalization constraint (1)

With N: number of studied DMU.

vi ⱖ 0 ∀i ⫽ 1… …p Non-negativity constraint
␷r ⱖ 0 ∀r ⫽ 1… …q

Vrj ⫽ ␷rYrj/ 兺 r⫽1

q
␷rYrj is the contribution of each partial indicator, as presented in the previous
section in the construction of composite indicator;
DMUj consumes amount Xij of input i and produces amount Yrj of output r
(sub-indicators);
CI0 is a composite indicator (CI) for a given country. The authors obtain 0 ⱕ CI ⱕ 100
(expressed as a percentage) for each country j. A score close to 100 indicates a better relative
financial sector performance;
i means sub-indicators;
Xi0 equal to unit;
vi is the weight of the ith indicator: The highest relative weights are assigned to the
sub-indicators for which the country j achieves the best relative financial sector performance
in comparison to the other countries. The weights are not fixed a priori; the only restriction
in the formulation above is that they should be non-negative, which implies that the CI is a
non-decreasing function of the sub-indicators (non-negativity constraint). In the financial
composite index case, each sub-indicator/output i has the following interpretation: if Yij ⬎
Yik, then country j has a more developed financial market than country k. The normalization
constraint means that no country in the sample can achieve a value that is greater than unity
under these weights.
The estimation of the composite indicators was carried out with the software EMS 3.1.
The second step involved the use of a bivariate vector autoregressive model (bVAR) to
analyze the long-term relationships between financial deepening and economic growth. The
first level of the bVAR study is to determine whether the series are stationary or not. In a
model, to ensure a correct evaluation, time series should be separated from all effects and the
 series should be stationary. Thus, logarithms of time series were taken. The augmented Islamic finance
Dickey-Fuller [(1981) ADP] and Phillips and Perron [(1988) PP] tests were used. The lag and economic
length of each variable is based on the minimum values of Schwarz information criterion
(SIC) statistics, and the max lag is four. The test equations include constant and trend as in
growth
the following:

k⫺1
9
Lt ⫽ ␮ ⫹ ␤t ⫹ 兺 ␳ ⌬L
i⫽1
i t⫺i ⫹ ␣Lt⫺1 ⫹ ␧t (2)

where, ␧t i.i.d.N (0,␴␧2 ) and L 僆 兵R_GDP, P_Credit, M2, T_Credit, Is_Invest其. The variables
are to be tested for non-stationary. The null hypothesis is the variable L contains unit root
and the alternative is the variable L is stationary (integrated of order 0, I(0)).
Then, Johansen cointergration test was applied to examine the long-term relationship
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between financial development and economic growth. In this case, established numbers of
lag are very important. In this study, Akaike information criteria (AIC) were adopted for
selecting the optimal lag. In addition, in all models, stability test was used and
auto-correlation tests to residuals were made. Models were generally stable and residuals
were not auto-correlated. And then, the Granger causality test was practiced to test the
causality between financial development, Islamic finance and economic growth. The
separate effect of Islamic bank development on real economic activity was distinguished.
The authors estimate the following regression equations:

k k

Yt ⫽ ␥ ⫹ 兺␣Y
i⫽1
i t⫺i ⫹ 兺␤ X
i⫽1
i t⫺i ⫹ ␷t (3)

k k

Xt ⫽ ␾ ⫹ 兺i⫽1
␦iYt⫺i ⫹ 兺␭ X
i⫽1
i t⫺i ⫹ ␩t (4)

where, Y ⫽ R_GDP and X 僆 兵P_Credit, M2, T_Credit, Is_Invest其

␷t and ␩t are the respective intercepts and are white noise error terms, and k is the
maximum lag length used in each time series.
X Granger causes Y if the ␤i coefficients are jointly significantly different from zero.
Similarly, Y Granger causes X if the ␦i coefficients are jointly and significantly different from
zero.
Eviews software was used to test and analyze the results.
The third step was a VAR forecasting procedure to investigate a statistical association or
correlation pattern among variables, without imposing strong restrictions relating to the
structure of the economy, and then to use this information to predict likely future values for
each of the endogenous variables. The authors assumed that the relationship which existed
in the past between two variables will continue to exist in the future. Given that real GDP
forms part of every single model, the authors built the different VAR specifications by
permuting the candidate variables. All series were transformed with a natural logarithm to
improve their statistical properties and not seasonally adjusted, as seasonal adjustment
procedures generally apply two-sided filters and consequently, for any given point in the
past, give future information that was not available at the time of measurement. Enders
(1995) suggested that the lag lengths of the single VAR model are dynamically optimized
using the lowest values of AIC.
 JIABR 4. Empirical results and discussion
8,1 Table II presents summary statistics about the variables used in the econometric analysis for
the UAE country during the period 1990-2012. It shows that standard deviation of all
variables is very high which means that the data points are spread out over a large range of
values.
Table III provides empirical correlations between variables. The results reveal that
10 several variables are correlated and in the expected direction but show signs of potential
collinearity.
Figure 2 indicates a continuous development of the financial sector. Going forward with
a number of years of soft growth, bank credit has been caught and non-performing loans
have begun to decline for the first time since the crisis, as indicated in Table IV.
The Central Bank of the United Arab Emirates (CBU) established macroprudential
policies to preserve the strength of the financial sector. The CBU is reviewing and updating
regulations to reinforce the prudential frame parallel with the requirements of Basel III.
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However, the sector has been negatively affected by the global financial crisis, as indicated in
Figure 2, experiencing a fall in all financial variables during 2009.
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

Variable Observation Mean SD Minimum Maximum

P_Credit 23 42.21178 16.97754 25.19651 84.04829

M2 23 45.23802 14.34363 31.16615 79.14568
T_Credit 23 44.9356 24.48113 23.17465 103.4799
Is_Invest 23 0.74022 0.57667 0.15528 1.86946
R_GDP 23 1.43e⫹11 4.62e⫹10 7.46e⫹10 2.12e⫹11
Table II.
Summary statistics Source: Authors’ calculations

Variable P_Credit M2 T_Credit Is_Invest

P_Credit 1.0000
M2 0.9760 1.0000
T_Credit 0.9866 0.9644 1.0000
Is_Invest 0.9393 0.9359 0.9393 1.0000
Table III.
Correlation matrix Source: Authors’ calculations
 Islamic finance
and economic
growth

11
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Figure 2.
UAE’ Financial
indicators (1990 – 2012
in per cent of GDP)
 JIABR recovery has been supported by the tourism and hospitality sectors as well as public projects
8,1 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
12 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
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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).

Financial ratio 2008 2009 2010 2011 2012 2013

Capital adequacy ratio 13.0 19.9 20.7 20.0 21.2 19.3

Table IV. Return on assets 1.4 1.4 1.3 1.5 2.0 2.0
Bank financial Return on equity 13.0 10.9 10.4 11.4 11.5 15.3
soundness indicators
(%) Source: International Monetary Fund

Figure 3.
UAE real GDP
(1990-2012)
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Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Bahrain 0.35 0.50 0.57 0.56 0.55 0.55 0.50 0.49 0.55 0.50 0.39 0.41 0.44 0.40 0.37 0.36 0.34 0.38 0.38 0.44 0.43 0.43 0.45
Bangladesh 0.18 0.20 0.22 0.23 0.24 0.25 0.23 0.22 0.21 0.21 0.23 0.27 0.31 0.30 0.31 0.32 0.28 0.27 0.27 0.28 0.30 0.32 0.32
Iran, Islamic Rep 0.49 0.38 0.46 0.39 0.41 0.33 0.31 0.30 0.31 0.28 0.21 0.23 0.22 0.24 0.24 0.24 0.25 0.24 0.19 0.21 0.10 0.09 0.09
Kuwait 0.99 1.00 0.98 0.78 0.82 0.78 0.62 0.62 0.70 0.61 0.44 0.53 0.56 0.54 0.45 0.39 0.36 0.38 0.33 0.45 0.41 0.37 0.34
Lebanon 1.00 0.87 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Malaysia 0.66 0.74 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 0.98 0.90 0.83 0.78 0.71 0.62 0.72 0.70 0.76 0.80
Pakistan 0.38 0.35 0.49 0.49 0.46 0.40 0.38 0.36 0.34 0.33 0.24 0.22 0.24 0.26 0.27 0.28 0.23 0.25 0.26 0.22 0.23 0.22 0.24
Qatar 0.39 0.56 0.60 0.58 0.61 0.54 0.47 0.39 0.46 0.44 0.27 0.35 0.33 0.31 0.27 0.29 0.28 0.30 0.26 0.35 0.34 0.36 0.40
Saudi Arabia 0.22 0.29 0.35 0.39 0.39 0.38 0.33 0.31 0.35 0.30 0.26 0.27 0.31 0.29 0.29 0.28 0.27 0.28 0.25 0.32 0.28 0.25 0.28
Turkey 0.18 0.22 0.25 0.23 0.27 0.27 0.29 0.27 0.20 0.24 0.22 0.28 0.27 0.24 0.22 0.26 0.25 0.27 0.28 0.31 0.34 0.36 0.38
United Arab Emirates 0.26 0.31 0.32 0.29 0.30 0.29 0.26 0.25 0.27 0.26 0.26 0.28 0.31 0.31 0.31 0.33 0.32 0.36 0.36 0.48 0.46 0.42 0.39
United Kingdom 1.00 1.00 0.96 0.96 0.96 0.88 0.81 0.71 0.76 0.80 0.97 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

Notes: The aggregate index of financial development is composed of the domestic credit to private sector by banks as a percentage of (GDP), money and
quasi-money (M2) as a percentage of GDP and domestic credit provided by financial sector as a percentage of GDP. Data are taken from Beck et al. (2000) and World
Bank’s World Development Indicators. The authors use the data envelopment analysis (DEA) approach
Source: Authors’ calculations
13

Countries’ index
Table V.
growth
and economic
Islamic finance
 JIABR As all variables are determined I(1), the second step is to investigate the cointergration
8,1 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
14 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].
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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

ADF Test PP Test

Variable Level data First difference Level data First difference

P_Credit ⫺1.577 ⫺2.684* ⫺1.309 ⫺2.548**

M2 ⫺2.100 ⫺1.824** ⫺2.079 ⫺5.143***
T_Credit ⫺1.460 ⫺2.240** ⫺1.754 ⫺2.583**
Is_Invst ⫺0.796 ⫺3.917** ⫺1.529 ⫺3.931**
R_GDP ⫺2.207 ⫺5.352*** ⫺2.515 ⫺5.259***

Table VI. Note: *** , ** and * indicate significance at 0.01, 0.05 and 0.10 level respectively
Unit root test Source: Authors’ calculations

Hypothesized Max eigenvalue 5% critical Trace 5% critical

Variable cointegrating rank statistics values statistics values

R_GDP & P_Credit r⫽0 13.04 14.07 13.50 15.41

rⱕ1 0.45 3.76 0.45 3.76
R_GDP & M2 r⫽0 12.42 14.07 13.31 15.41
rⱕ1 0.89 3.76 0.89 3.76
R_GDP & T_Credit r⫽0 8.33 14.07 9.12 15.41
rⱕ1 0.78 3.76 0.78 3.76
R_GDP & Is_Invst r⫽0 6.51 14.07 6.99 15.41
Table VII. rⱕ1 0.47 3.76 0.47 3.76
Johansan cointegration
test Source: Authors’ calculations
 Null hypothesis F statistic Probability
Islamic finance
and economic
Index does not Granger Cause R_GDP 8.4966*** 0.0031 growth
R_GDP does not Granger Cause Index 3.0858* 0.0736
P_Credit does not Granger Cause R_GDP 4.453** 0.0253
R_GDP does not Granger Cause P_Credit 2.6564* 0.0958
M2 does not Granger Cause R_GDP 2.6804* 0.0939
R_GDP does not Granger Cause M2 2.1524 0.1484 15
T_Credit does not Granger Cause R_GDP 3.3312** 0.0459
R_GDP does not Granger Cause T_Credit 1.3541 0.3166
Is_Invst does not Granger Cause R_GDP 1.0023 0.4505
R_GDP does not Granger Cause Is_Invst 3.3618** 0.0446
Table VIII.
Note: *** , ** and * indicate significance at 0.01, 0.05 and 0.10 level respectively Granger causality
Source: Authors’ calculations tests
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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
 JIABR the period 2008-2012 (Deutsch-Emiratisch Industrie and Undelshammer, 2013), making it a
8,1 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
16 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
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(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.

Year 2013 2012 2011 2005 2000 1990

Table IX. Islamic banks’ total deposits 62,316 56,640 40,854 15,734 3,763 736
Islamic banking in Islamic banks’ total investment 62,151 56,688 44,368 17,933 4,364 787
UAE 2013 (million
US$) Source: IBIS data base
 Although forecasting is difficult under the conditions of a relatively short series in a certain Islamic finance
period, the results of the presented forecasting models are not negligible, as Figure 4 and economic
indicates, and could provide important use value for further work in this field. The results growth
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 17
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.
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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
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8,1

18
JIABR

Figure 4.
Forecasting 2013-2022
 Islamic finance
and economic
growth

19

Figure 5.
Forecast natural
logarithm of R_GDP
2013-2020
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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
 JIABR 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.
8,1
5. Source: Authors’ calculation and IBIS data base.

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About the authors

Dr Hajer Zarrouk holds a Master in Banking and Monetary Economics (2002) and has a PhD in
economics (2008) from University of Mediterranean, France and University of Tunis El-Manar, Tunisia.
She holds a Master in Islamic Finance (2014) from AIMS-UK and she’s a Certified Islamic Finance
Expert and Executive (2013) from Ethica institute. Currently she’s a program coordinator of banking
and finance and an assistant professor at Emirates College of Technology, UAE. She started her career
as a teacher since 2003 at ISCAE, University of Mannouba, Tunisia. Dr Zarrouk’s research interests
include banking and monetary economics, Islamic finance, bank performance, financial crisis, financial
liberalization, financial development and economic performance. She’s the author of several research
studies published in refereed journals and has presented papers in many international conferences. Dr
Hajer was the treasurer (2009-2012) and in charge of external relationship (2007-2009) of the Tunisian
Economists Association. She is a member of research center Laboratoire de Prospective, de Stratégie et
de Développement Durable. She has participated in many scientific activities such as organization of
trainings and participated in committee organization of several international symposiums.
Hajer Zarrouk is the corresponding author and can be contacted at: hzarrouk09@gmail.com
Teheni El Ghak is Assistant Professor of Economics at Higher Institute of Management (Tunisia).
She received her Ph D in economics with distinction at Faculty of Economics and Management of Tunis
in 2011. Before, she had studied at Commercial High School of Tunis. Her main research interests are
growth, productivity and financial development.
Dr Elias Abu AL Haija holds a PhD in economics & Islamic banking from Yarmouk University,
Jordan. Also a Master in Finance major Islamic Banking and holds a Certified Lender Business Banking
(CLBB) certificate from Arab Academy. Currently he’s an assistant professor in banking and finance
department at Emirates College of Technology, UAE since 2012. He started his career working in JIB
(Member of Al-Baraka Banking Group/ABG – Bahrain) 1991-2011; the last position was Director of risk
management department. Dr. Elias has a wide experience in Islamic Finance, classified as an expert in
banking sector/Islamic banking. He is a professional trainer providing a lot of training courses in many
countries. He participated in many conferences, works shops, and training courses related to Islamic
Finance.

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