Beset by Western sanctions, Russia is hoping to form financial ties with the Islamic world. Dave Waller reports on Moscowâs efforts to embrace sharia-compliant investment.
In medieval times, Arabs in the Ottoman Empire built trade relationships with the Spanish. Together they established financial systems that operated without interest, and where both parties shared in profits and losses. This model may seem alien in a world dominated by Western-style transactions, but its lineage can still be seen in sharia-compliant Islamic finance.
Indeed, Islamic finance couldn’t be more current. Islamic capital is now worth around $1.3 trillion, according to Emad Mostaque, a London-based strategist at emerging markets consultancy company Ecstrat. EY, the multinational professional services firm, says the total will almost double by 2018.
Amid this growth, Islamic finance is attracting a number of converts. The latest is Russia. In July, Sberbank, the country’s largest bank, signed an agreement with the Russian republic of Tatarstan to co-operate on developing Islamic financing in the region. Vnesheconombank, Russia’s state development bank, expressed interest in selling its first Islamic bonds in December. And Jeddah-based Islamic Development Bank announced plans to meet with Russia’s central bank in the summer to discuss co-operation in sharia-compliant banking too.
This movement has gained support from unlikely quarters. The Russian Orthodox Church has announced it is working with the lower house of the Russian Parliament to develop a financial system that doesn’t involve interest. Given that the Orthodox Church is the predominant faith of Russia’s 142 million population, it is helpful for the Islamic finance cause that the two share much ethical common ground.
But beyond the moral principles, there’s a more immediate driver. Russia has been pushed towards a financial crisis by sanctions imposed by the US and the EU against Russian individuals and businesses back in March 2014. The sanctions, inflicted in retaliation for Russia’s activities in Ukraine, helped to shrink the country’s GDP by 4.2% in the year ending in April, according to government figures. Sberbank has struggled considerably in 2014, with a 19% fall in profits.
Naturally, this economic blow has prompted Russia to look to sources of capital outside the seemingly hostile Western countries. In this environment, the idea of tapping wealthy Muslim investors is appealing.
“Islamic finance is developing into an additional pool of liquidity for funding and investment, and is more prevalent in high-growth Gulf and Asian countries,” says Khalid Howladar, global head of the Islamic finance group for ratings agency Moody’s. “Given the difficulty Russian issuers currently face in obtaining funding in Western capital markets, it’s not surprising that issuers in the country have begun exploring a number of alternative sources of financing, such as Islamic finance.”
Others have described the situation in more direct terms. “The more you pressure Russians, the more united they become, and they start looking for other options,” Linar Yakupov, president of the Islamic Business and Finance Development Fund, told the IFN Investor Forum in Dubai in April, as reported by Funds Global MENA.
LEARNING PROCESS
The big question concerns how Moscow intends to incorporate the Islamic finance model into its existing conventional system. In May, Russia’s finance ministry rejected a draft law that would have allowed such alternative finance models to exist.
“Islamic Finance in Russia is at an early stage and is just a learning process among bankers and borrowers,” says Howladar. “But Islamic financing regulations need to be developed to be consistent with Russian laws and regulations. This is an essential practical step.”
Early adopter Sberbank is one of the most profitable banks in the region and accounts for two-thirds of revenue earned by the banking sector in Russia. And with a majority Muslim population, Tatarstan could well be a crucial testing ground. But while Russia seems well set-up in many respects, Islamic finance may yet remain a niche concern in terms of domestic demand. Some researchers estimate that 14% of Russians are Muslim, though other polls suggest the figure is only 6%.
“Given large infrastructure investment requirements and strong central control, Russia should be successful in developing a solid sukuk offering at the very least,” says Mostaque of Ecstrat (sukuk are sharia-compliant bonds). “But consumer-oriented sharia-compliant products are unlikely to gain as much traction as Russia lacks the critical mass and broad product awareness for this.”
Yet the need for alternative financial models is being felt keenly. “Issuance is now picking up steam as hydrocarbon majors face deficits and take pause to consider how to more effectively deploy their vast sovereign assets in a more impactful way than investing in US treasuries,” says Mostaque. “Particularly when trade with the US is decreasing and the focus is turning to Asia.”
Of course, Russia isn’t the first country to toy with opening its doors to Islamic finance. While strongly Muslim nations such as Malaysia, Indonesia and the Gulf countries have been the main centres for sharia-compliant investment, others further afield have spotted the obvious benefits of attracting more investment from the Islamic world.
In 2014, the UK government became the first in the West to carry out a sukuk issuance. The £200 million ($310 million) sale was vastly over-subscribed, attracting orders of £2.3 billion.
“The UK has been particularly active with sukuk issuances, industry events and government support to stimulate the growth of Islamic financial services and foster greater investment,” says Moody’s Howladar.
LIQUIDITY POOLS
So how big a presence does Islamic finance have in the UK? It is already massive, says Omar Shaikh of the UK Islamic Finance Council. “There are five brand new banks in the UK that are totally sharia-compliant. The largest alone has a £1 billion-plus balance sheet. The Shard, the tallest tower in Europe, was funded via sharia financing. Then there’s the Battersea regeneration, Chelsea Barracks and a number of student accommodation deals. Such direct real estate deals are comfortably in the region of the billion pound mark. And that’s before you get to capital markets and funds managed out of London.
“Islamic finance is seen as a great way for a country to tap into the deep liquidity pools and sovereign funds from the Gulf,” he adds. “They’re some of the largest sovereign wealth funds in the world, and increasingly prefer to deploy using sharia-compliant vehicles. The five standalone Islamic banks in the UK are all funded via Middle East liquidity.”
But the UK was not the first to establish these links. In 1978, Luxembourg was host to the first Islamic finance institution to be established in a non-Muslim country. Its stock exchange was the first to list a sukuk in 2002. Since then, issuers from Malaysia, Pakistan, Saudi Arabia, the UAE, Bahrain, Qatar, South Africa, the USA, Hong Kong and Europe have listed sukuk in the country, before Luxembourg itself issued the first sovereign euro-denominated sukuk in 2014. Luxembourg has also flourished as a domicile for Islamic investment funds. It is the third-largest domicile in the world for sharia-compliant mutual funds after Malaysia and Saudi Arabia.
The Russian government clearly has work to do if it is to develop a domestic Islamic finance industry of any size. It will not be easy. But, given Russia’s increasingly tense relationship with the West, forming ties with Muslim investors elsewhere could be a smart move.
“Everyone wants to be open to sharia-compliant flows,” says Mostaque. “But a country such as Russia, shut out of some of the global finance system, has increased pressure to make its foray a success.”
©2015 funds global mena