Revisiting the impact of Islamic finance on economic growth: a decomposition analysis using Indonesia as a testing ground

Purpose: This study aims to examine the impact of Sharia-compliant (SC) finance on economic growth by decomposing it into working capital, investment and household finance. The goal is to understand not only the general impact of Islamic financing but also how its various components contribute to economic development. Design/methodology/approach: Using annual data from 33 provinces in Indonesia from 2010 to 2021, the authors use the fixed effects model, accounting for cross-sectional heterogeneity. The study explores the competitive dynamics between Islamic and conventional banking, focusing on how Sharia financing market share affects economic growth. Robustness checks ensure the reliability of the findings. Findings: The results show that total Islamic financing and its components (working capital, investment and household finance) positively impact economic growth. However, a higher market share of Sharia financing can constrain growth, suggesting an underdeveloped market for SC products. This finding emphasizes the need for a balanced development of both Islamic and conventional financial sectors to support sustainable economic growth. Research limitations/implications: Future research could extend the time frame or investigate other emerging markets to confirm these results. Further studies could also explore how different types of Sharia financing affect specific sectors, such as agriculture or manufacturing, to offer more targeted insights for policymakers and investors. Practical implications: Policymakers could use the insights from this study to create incentives for Islamic financial institutions to develop tailored products for critical sectors, such as microfinance for smallholder farmers or investment financing for sustainable agriculture. These initiatives would enhance access to finance, stimulate local economies and align with Indonesia’s development goals. Social implications: Understanding the role of Sharia financing in growth can help devise strategies that promote ethical investment and reduce poverty. The findings highlight the potential of SC finance to contribute to social welfare and economic equity. Originality/value: This study provides a unique analysis of how different forms of SC finance affect economic development, filling a gap in the literature. It offers valuable insights for academics, policymakers and practitioners in the field of Islamic finance, emphasizing the nuanced relationship between financial structure and economic growth. Contribution to impact: This study contributes to the literature by analyzing the decomposition of Sharia financing into specific categories and their distinct impacts on growth. It suggests that existing models need to account for market development and competitive dynamics when evaluating the role of Islamic finance in economic development.