The Kazakhstan government is strongly promoting the development of Islamic finance in the country to diversify its financial sector, with strong support from Abu Dhabi. Writer Philip Alexander

The growth of Islamic finance in Kazakhstan is shaping up to be a tussle between history and modernity - but perhaps not in the way one might expect. Historically, religious practice was frowned upon during the Soviet era, and many Kazakhs are only now rediscovering their Muslim roots. Today, however, the financial crisis that hit Kazakhstan's banks especially hard has encouraged both banking professionals and their customers alike to look more closely at alternative models.

"The crisis has definitely increased interest in Islamic finance, but it has also increased wrong perceptions about Islamic finance; many people are understanding Islamic banks as some kind of charitable organisations that will end the crisis by just giving out money," says Yedige Alpysbay, who founded Kausar Consulting, the country's first dedicated Islamic finance consultancy, in 2008. Mr Alpysbay typifies the new generation of Kazakh professionals investigating the possibilities that Islamic finance can offer. He became interested in the subject as a doctoral student in 2002, but found he had to work outside Kazakhstan, with Turkish participation banks and Malaysian Islamic banks, to acquire the necessary experience.

International assistance

The Kazakh government has followed the same route. In early 2009, the authorities signed an agreement with the government of the United Arab Emirates to establish the first Islamic bank in Kazakhstan. Al Hilal, which is owned by the Abu Dhabi government, was chosen to fulfil this agreement, and the Kazakh subsidiary began operations in March 2010. Given the significance of this deal at the highest level, Al Hilal has taken its new venture very seriously indeed, appointing its former chief financial officer Prasad Abraham to head the Almaty office. Kazakh officials apparently anticipate that Abu Dhabi will ultimately channel about $1bn through Al Hilal, mainly for projects to improve Kazakh infrastructure.

From September 2009, Mr Abraham conducted about 200 job interviews with potential staff from his hotel room during one-week visits, before selecting 40 staff. His recruitment drive took place at the peak of the financial crisis, making it a little easier to find the right skills in a competitive market that often has high staff turnover.

"We make sure that there is a family spirit, sending a large number of our staff to the UAE to get training. Approximately 30% of our staff joined us because of a genuine interest in Islamic banking, they had exposure to Islamic banking in the past, and they decided to join because it was something they had cherished for a while," says Mr Abraham.

As the bank originated from an intergovernmental deal, it will initially focus on supporting Kazakh government-led projects and large state-owned enterprises. Mr Abraham anticipates using tried-and-tested structures such as commodity murabaha and ijara (leasing) deals first.

Mr Alpysbay agrees with this assessment, because other Islamic finance vehicles such as mudaraba or musharakah are based on equity participation or partnership principles, which require company owners to share a stake and enunciate their business plans and financial position more clearly. He says many Kazakh businessmen will need to change their "mental processes" to understand and trust this concept.

"We need some time to educate people that you should not be afraid to open your business to investors, because it is in your interest that they learn about your business. The period of the Soviet Union and the early post-Soviet times educated people to doubt those around them," says Mr Alpysbay.

Sovereign benchmark

To help smooth a path for companies to tap wholesale Islamic financing, the Kazakh government is intending to establish its own sukuk benchmark, most likely in the second half of 2010. Arken Arystanov, chairman of the regulatory agency for the Regional Financial Centre of Almaty, says the government is in the process of making legal changes to permit the finance ministry to issue a sukuk, both to domestic and foreign investors.

For the local issuance, legislation passed in April 2009 allows Islamic financial instruments to be listed on the Kazakhstan Stock Exchange. HSBC appears to have a head start in any tender for arrangers on an eventual deal.

"We are working very closely with the Ministry of Finance to ensure that the legal foundations are there for this sukuk. HSBC has been involved in every sovereign sukuk transaction to date, and we hope that will continue in Kazakhstan. We think it is an important transaction to open this market for Kazakhstan," says Simen Munter, HSBC's country head in Kazakhstan.

Legal changes

Mr Arystanov says the authorities are aiming to attract about $8bn in inward investment from Islamic banks over the coming decade, including the Al Hilal deal. But the April 2009 legislative framework for Islamic banks is still a work in progress. The tax treatment of Islamic finance is evolving, and conventional banks cannot yet open Islamic windows. Mr Arystanov is involved in work on both these aspects, as he sits on the board of the Financial Supervision Agency (AFN) and is also looking at the process for registering real estate.

"Real-estate registration is especially connected to Islamic finance, because we must avoid double taxation when Islamic banks use their real estate as an asset for financing," he says.

On Islamic windows, the National Bank of Kazakhstan (NBK) and AFN were apparently concerned about the need for banks to segregate Islamic funds from conventional liquidity, given the different accounting methods that apply to the two pools. Mr Arystanov is keen to use the example of Malaysian and international banking groups that offer Islamic windows to overcome the anxieties of the AFN and NBK.

"We are now in discussion with NBK and AFN to decide if there will be such an opportunity for conventional banks or not. My belief is that they should have this opportunity, because they could spread Islamic banking in Kazakhstan very fast," he says.

So far, domestic Kazakh banks have not shown intense interest in opening sharia-compliant operations. Only BTA Bank used Islamic instruments to fund itself in the wholesale markets, and this has not been a helpful example, because those notes are now part of the general restructuring process at the troubled bank. The most likely first mover if the restriction on Islamic windows is lifted would be HSBC, using its Amanah brand.

"We are discussing with the government ways to open Islamic windows. We think it is fully doable, and we would want to offer Amanah financing through an Islamic window. We don't believe that Islamic finance will transform the Kazakh economy, but we do believe that there is room for Islamic finance in this market," says Mr Munter.

Retail market potential

Once the secular legal framework is in place, the next step will be the choice of sharia compliance standards in Kazakhstan. Mr Alpysbay sees this as a two-stage process. At first, to attract foreign Islamic investors, the country should adhere to the standards set out by the Accounting and Auditing Organisation for Islamic Financial Institutions, which are widely recognised in the Gulf states and Malaysia.

But in the long term, Mr Alpysbay hopes that Kazakh Islamic finance will adapt to suit the local population. Kazakh Muslims are predominantly from the Sunni Hanafi school. This school is not generally followed in the two largest Islamic finance markets, Malaysia and the Gulf states, but it is more common in Turkey and Pakistan.

The Kazakh Academy of Banking, which grew out of the Soviet-era training school for bankers, will offer a course in Islamic finance from the 2010/11 academic year, with assistance from training and certification programmes in Bahrain and London. Al Hilal's sharia supervisory board has agreed to recruit a Kazakh scholar in due course.

"This is to brief the board about local sensitivities and make them aware of local conditions, and also to further increase the awareness of Islamic banking within the local community by engaging more people from the local market place," says Mr Abraham.

He adds that he would welcome further competition from Islamic banks or windows in the Kazakh market, because it would help to raise the profile of the sharia-compliant model, enabling demand to grow more quickly for all sector participants. He also believes the liability side of the business will need time to establish a track record capable of winning over customers.

"In a conventional bank, the customer walks in and the sales assistant will say the deal is a deposit rate of X%. In an Islamic bank, we do not guarantee a profit rate; we will invest your money in certain assets, and depending on how those assets perform, we will give you a return. When a bank has a track record, we can say that for the past six months, the deposit money that we use to fund assets has offered a rate of X%. That's not a guarantee for the future, but it gives customers something to relate to. Today, I'm just starting my operation," says Mr Abraham.

Mr Munter of HSBC says clients may have several motivations for turning to Islamic finance. The search for competitively priced financing will clearly be one of them.

"But we know that there are a set of clients, both retail and corporate, who would prefer to do Islamic transactions if given the choice. I am more hesitant to see a market for people willing to pay extra for Islamic finance," he says.

Although corporate lending will be the starting point, Mr Alpysbay believes the Islamic finance model has good potential in retail segments that are neglected by conventional banking, perhaps two to three years from now. In particular, he is excited by foreign investment funds and insurance companies looking to enter takaful (Islamic insurance) and sharia-compliant microfinance activities in Kazakhstan.

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