Question

Indonesia is a predominately Muslim country and Islam prohibits the charging of interest on loans. Why then is the Indonesian economy so dependent on debt and has underdeveloped equity markets?

Answer 1

Islamic Banking  in Indonesia

Industrial production, is a highly determinant factor of Islamic bank deposits, while inflation, as measured by the customer price index, is the determinant factor of Islamic bank financing. Also a mix of dynamic behaviors from both Islamic bank savings and financing is in response to the shock of the macroeconomic variable, giving better insight for the government and stakeholders into Indonesian Islamic banking.

Furthermore,The larger Islamic population and its need for a financial intermediary based on both religious beliefs and the direct Indonesian law of banking (Number 7, 1992) led to the creation of the dual banking system, which is both a conventional banking system and a Sharia banking system. The Sharia banking system, or Islamic banking, refers to banks based on Islamic (Sharia) laws and practices, which completely prohibit interest activity and the trade of elements that are prohibited by Islamic culture.

Banks operating under the Islamic tenets are expected to generate and disburse funds under specified agreements, including profit-sharing agreements, whereby the profits that arise from the use of funds are shared between the banks and the borrowers on the one hand and the banks and the depositors on the other hand. In other words, borrowers and lenders engaged in
Islamic financial transactions are basically involved in venture financing, and therefore share the
associated profits and risks

However, while commercial banks are highly
dependent on loans to create more profit via interest rates, Islamic banks follow Islamic ethics and
use loan-financing options in which interest rates cannot be charged. In the dual banking system, the ability of both conventional and Islamic banks to attract customers and survive under economically
uncertain conditions will determine their banking business.
Although the market share of Islamic banking in Indonesia was relatively small at around 5% in
2016, the industry showed a faster growth rate compared to conventional banks. For many years, the
Islamic banking sector has been growing at a double-digit pace, reaching its peak in 2011 after
recording a 50% increase in total assets. Since then, the percentage growth rate has started to decline
to 34.1%, 24.2%, and 12.4% in 2012, 2013, and 2014, respectively. Macroeconomic turmoil has also
been attributed to this declining growth rate, and in turn has significantly impacted the overall
growth of the industry

The negative consequences of adverse macroeconomic events saw a slowdown in Islamic
banking.

Conclusion

Exposed business cycles decreased the banks’ intermediary function within this sector. Therefore, interest-rate risks associated with changes in market interest rates constitute a central source of market risk for banks. Excessive exchange-rate volatility impairs
economic and financial stability in a country, and was found to have played a significant role in
inducing banking crises. An increased rate of inflation diminishes the real rates of return on bank assets and induces loan rationing

The interest rate was found to have no effect on Islamic banking deposits, clearly outlining the
differences between Islamic banks and conventional banks. As interest rates are prohibited, Islamic
bank depositors are not affected by them, while depositors in conventional banks will be interested
in the interest rate return on their deposit

In terms of the total value of stocks traded, Indonesia recorded the second-lowest figure of countries in the region, according to the World Development Indicators, 2015.
Also the firms in Indonesia still do not rely on equity or stocks as their sources of investment. Based on the Enterprise Survey, about 86 percent of investment was financed by internal revenues. Only 3 percent of investment is financed by equity and 6 percent by banks.

Thus we can say that even though Indonesia is a predominately Muslim country and Islam prohibits the charging of interest on loans, the Indonesian economy is so dependent on debt and has underdeveloped equity markets