Islamic Finance and Indonesia's Economy: An Empirical Analysis

Purpose – Islamic finance is becoming increasingly important both globally and in Indonesia. However, studies on the relationship between Islamic finance and Indonesia’s economy are scant. Therefore, this study aims to analyse the short-term and long-term relationship between Islamic finance and Indonesia’s economy. Methodology – This study uses monthly data for the period 2011–2020 which are estimated using the Vector Error Correction Model (VECM). The dependent variable is Indonesia’s Growth Domestic Product (GDP), while the independent variables are macroeconomic variables (gross fixed capital formation, trade openness and inflation), Islamic finance (Islamic banking, capital market and Sukuk) and a Covid-19 dummy variable.Findings – The study found a one-way causal relationship between Islamic finance and Indonesia’s economy. In the short term, Sukuk (Islamic bonds) has a significant effect on Indonesia’s GDP. While in the long term, Islamic banks and Islamic mutual funds are found to impact Indonesia’s GDP significantly. These results imply a positive relationship between Islamic finance and Indonesia’s GDP in both the short and long term. It is also notable that rates of investment, inflation and the occurrence of the Covid-19 pandemic have a significant impact on GDP.Originality – Most studies linking Islamic finance and economic size only use Islamic banking to proxy Islamic finance. However, while Islamic banking institutions dominate the Islamic finance landscape, non-bank Islamic financial institutions such as the capital market are becoming increasingly important in many countries, including Indonesia. This study fills the gap by incorporating Islamic capital market variables such as Islamic mutual funds and Sukuk to explain the relationship between Islamic finance and economic size in the world’s largest Muslim country.Research limitations – Due to data limitations, this study uses only Islamic mutual funds and Sukuk to represent non-bank financial institutions, which as a sector includes various other sub-sectors.Practical implications – Policymakers, industry and academics could use the research findings to accelerate the development of Islamic finance in Indonesia and strengthen its role in supporting and aiding the recovery of the Indonesian economy.