Dynamic Relationship between Islamic Banking System and Real Economic Activity: Evidence from Pakistan

This study examines the rapid expansion and diffusion of Islamic banking and its relationship with real economic activity in Pakistan. Additionally, the study also highlights the functional role of Islamic banking for greater economic activity and growth in Pakistan. Two major balance sheet items of Islamic banks (Islamic deposits and Islamic financing and investment) were used as proxies for Islamic banking development. The Large Scale Manufacturing Index (LSMI) was used as a proxy for real economic activity. Quarterly data was obtained from statistical bulletins of the State Bank of Pakistan. Robust time series techniques such as the JJ Cointegration Test, Granger Causality Test, Impulse Response Functions, and Variance Decomposition Analysis were used for the data analysis. The findings of the study unveil a significant positive and dynamic long term bi-directional causal relationship between Islamic banking and real economic activity. Furthermore, the findings also reinforce that the State Bank of Pakistan should continue promoting Islamic banking as a parallel banking system to the conventional system as it exerts a substantial positive impact on real economic activity in Pakistan.