THE ISSUES OF ISLAMIC FINANCE DEVELOPMENT ON POST-SOVIET AREA

Kairat Moldashev, MA Suleyman Demirel University, Almaty, Kazakhstan kairatm@gmail.com ABSTRACT The current paper explores the current situation and prospects of development of Islamic financial system on post-Soviet area. There are two major problems that limit the development of Islamic financial tools on post-Soviet area: the absence of special legal framework with Kazakhstan being an exception and the low transparency of doing business. Muslim population of Central Asian countries, Azerbaijan, and Russia is in need of financial instruments that confirm to shariah principles. The demand forecasts for Islamic financial tools based on ethnic groups statistics are also reconsidered with deeper analysis of these statistical data. The Kazakhstan case is given more space in analysis due to its importance as pilot state on postSoviet area that adopted legislation and welcomed full range of Islamic financial services. Key words: Islamic finance, Islamic banks in Kazakhstan, post-Soviet area. INTRODUCTION The recent world wide economic crisis unveiled the deep problems of mainstream economic system. The cyclical characteristic of economic instabilities and unfair allocation of capital have shown the need for revision of existing system. The financial market as the term and as the functioning mechanism can be viewed as the one of the main reasons of crisis. The money is no longer the medium of exchange. The unregulated financial market as the mechanism and free capital flows allowed people to treat money as commodity with real value. The last three decades are period of tremendous growth of financial market comparing to other commodity markets. Kazakhstan is a good case to explore the negative effects of the unequal development of financial sector over the real sectors of economy. The financial sector boomed in Kazakhstan in a few years before 2007. The development of this sector was not followed by improvements in other sectors except real estate sector which became highly speculative. The stable economic development of Kazakhstan, political stability, and high mineral resources prices allowed domestic banks to attract foreign capital which stimulated consumption and temporary development of financial sector. After the mortgage crisis in US, the real estate sector bubble (where most of the attracted capital was accumulated) exploded in Kazakhstan. Only the availability of oil fund reserves made it possible to avoid the bankruptcy of major banks and social instability caused by frozen construction. The severe shortage of financing for economic development caused by crisis of conventional banking system increased the need for alternative sources. The slow developments in introduction of Islamic financial system in Kazakhstan were catalyzed by the policy makers in order to attract capital. The government adopted the new legislation that outlined the rules for

implementation of Islamic financial instruments. As the long-term strategy of the state is to diversify economy and attraction of capital into real sectors of economy, the improvement of condition for Islamic financial tools is very logical. The recent developments are more top down and can be viewed as the efforts to widen the room for financial system that proved its stability during turbulent times. However, the social factor also plays significant role. In considering social impact on demand for Islamic financial tools on post-soviet area the distinction between cultural Muslims1 and practicing Muslims2 should be taken into account. The cultural Muslim population cannot be considered as potential market that is thirsty for financial instruments that fit shariah principles. They can use new tools as the alternative to conventional institutions products or to diversify their investments. Only practicing Muslims may have incentives to use shariah allowed instruments because of their religious views. The definition of practicing Muslims is used in social literature of post-Soviet countries to distinguish those people who practice religion by performing prayers, fasting, and following shariah principles. The distinction is made because the cultural Muslims are not always aware of shariah principles or even are in doubt of existence of God. The religion was prohibited in Soviet period and Darwinism was taught as the scientifically proved and only true theory. The figures on practicing Muslims are more accurate in having realistic picture of social factor. The current paper discusses some developments in form of Muslim oriented media in order to show the trend towards increasing in number of practicing Muslims. Also the survey of people registered on Halal technical committee was undertaken in order to measure the knowledge on Islamic finance among practicing Muslims. The doing business culture is another important factor influencing the development of Islamic financial system in post-Soviet countries. The Hilal Bank which the only bank operating in Kazakhstan to this date provides services only to corporate clients. The Islamic Development Bank involved only in government backed infrastructural projects. The Small and Medium Enterprises are out of Islamic financial institutions activities. The current article provides some insights from doing business culture in order to explain the situation and draw some conclusions. The entrepreneurship history of Kazakhstan and its neighbors sharing common soviet past starts from nineties of the last century after gaining independence. Under the command economy of communist party entrepreneurship was considered as speculation and was prohibited. Only in last decade before collapse of Soviet Union some forms of private business activity were allowed. The short history of entrepreneurship and complicated tax administration system limit the transparency of doing business. The profit loss sharing culture is not widespread and most of the small businesses are organized in form of Sole Proprietorship. The development of domestic companies after the independence was financed through debt instruments of conventional banking. The conventional banking tools mostly based on collateral and require less transparency as they do not share risks. On contrary, the Islamic financial institutions require higher levels of transparency due to participation in projects and risk sharing. This feature of Islamic financial
The term cultural Muslim is used for people who belong to ethnic group considered as traditionally Muslim. But it does not mean that a cultural Muslim follow shariah principles or even aware of such principles. The term practicing Muslims is used to distinguish people who follow shariah principles, perform prayers, fast in Ramadan.
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system can be considered as one of the factors limiting its development on post-Soviet area due to low transparency in doing business on post-Soviet area. Moreover, the legal basis for well functioning of shariah based institutions is in stage of development. Only Kazakhstan has adopted special legislation which needs further improvements. The Malaysian model of combining conventional and Islamic financial systems viewed as more suitable in early stage of development. The operations of Islamic financial institutions in other post-Soviet countries are based on existing legislation for conventional institutions that regulate profit and risk sharing arrangements. However, this situation limits the implementation of certain tools that require special legislation. LITERATURE REVIEW In discussions of potential of Islamic Financial system development in Central Asia and Russia many experts refer to proportion of Muslim population. It is considered that religious factor is main driving force for development of interest-free financial instruments. However, the Islamic financial institutions should not purely rely on religion factor in considering the demand for their services. The research by Haron, Ahmad, & Planisek (1994) indicated that only 40% of Muslims respondents perceive religious factor as the main one in choosing bank in Malaysia. The service quality found to be one of the most important factors affecting the choice of both Muslim and non-Muslim customers. The study of Malaysian corporate customers by Ahmad & Haron (2002) showed that only 11.1% of customers use Islamic financial instruments strictly for religious reasons. The economic reasons and bank reputation play significant role as the selection criteria. This conclusions did not lessen the importance of religious factor but rather emphasize the importance of economic and other factors in development of Islamic financial system. The Muslim population is still driving force for development of instruments that fit shariah principles. The officials and representatives of different enterprises often refer to demographic data on Muslim population in post-Soviet countries in order to emphasize demand for Islamic financial products and make some predictions on development. However, this numbers are based on statistic of ethnic groups. Certain ethnic groups such as Kazakhs, Uzbeks, Tatars, Kyrgyzs, Turkmens, Chechens, and other are included in the statistics of Muslim population. Generally the above ethnic groups traditions are based on islam and they can show more loyalty towards Islamic financial products. However, in making demand estimations and formualting growth strategies there is a need for deeper analysis of statistical data. Filatov & Lunkin (2005) analysed the statistical data on religiousity in Russia. They indicate that leader of religious groups use the statistics that help to magnify their influence. In analysis of statistics of Pravoslav Chrisitians, Catholics, and Muslims they found that the mostly used criteria is the belonging to certain ethnic group. According to 2002 census in Russia the number of Muslims is abount 14 million people. As the demand for Islamic financial tools is seriously influneced by reliogiousity, this issue needs deeper analysis. Being a member of certain ethnic group which is traditionally Muslim is not proper measurement of religiousity that leads to increased demand for Islamic financial tools. The religiousity is often measured by persons practice of religion. Church attendance and chuarch membership are often used as indicators of religiousity in US studies (Wilkes, Burnett, & Howell, 1986). The attitude of person towards religion and God are also used as a measure of religiosity.

The study of Kaariainen & Furman, (1999) showed that only 77% of Tatar respondents positevely answered the question concerning their belief in existense of God and 31% indicated that religion is very important for them. The last decade of islam flourishing on post-Soviet area should have significantly changed the patterns of religiosity among Tatars and other etnic groups. But still the large portion of population considered as culturally Muslim may be attracted by Islamic financial institutions mostly using economic reasons rahter than religious ones. In analyzing the prospects of developments of Islamic Financial system in post-Soviet area one should keep in mind cultural issues. The suppliers of capital are investors or partners according to shariah principles. They can not be creditors that require fixed percentage. The role of investors and partners requires more transparency from businesses or individuals willing to use Islamic financial tools. The credit boom of 2004-2007 was mainly caused by banks poor credit management. When companies and individuals were allowed to have loans on huge percentage but with limited investigation on purposes and creditworhtiness. The reliance on collaterals and high fixed return schemes resulted in many banks having poor credit portfolio. The PIF and venture capital was underdeveloped in Kazakhstan before crisis. The tools of Islamic finance are more similar to venture capital arrangements. In analyzing the development of Islamic Finance in UK (Ainley, Mashayekhi, Hicks, Rahman, & Ravalia, 2007) emphisized the importance of law adopted in 2003. The law enabled functioning of financial tools that fit shariah principles wtihin the legal framework of state. Ainley et al., (2007) indicates that poor legal framework was one of the major barriers in development of Islamic finance. The customers have lower degree of protection comparing to conventional financial tools which weakened the competitiveness of Islamic financial products (Ainley et al., 2007). Some of the Islamic financial tools can be applied within the existing legal framework for conventional financial tools. However, the application of most of the instruments requires special legislation adopted according to shariah principles. The absence of such legislation limits the devlopment of Islamic financial system. THE PROSPECTS OF DEVELOPMENT: RELIGIOUSITY DIMENSION In analyzing the prospect of Islamic financial system development on post-Soviet area two major reasons of why people may switch from conventional to Islamic financial tools are taken into account. In choosing the source or the destination for capital economic reasons usually prevail. However, the religiousity also palys significant role in countries with higher proportion of Muslim population. Central Asia countries, Azerbaijan, and some region of Russia are territories where islam was dominant religion. The Soviet Union strictly prohibited the practise of religion and presented it to the masses as he opium for mind. The collapse of communist regime made it possible to Muslim population learn and practice religion. In last two decades islam flourished in post-Soviet area. In many studies and reports the statistics of ethnc groups associated with islam are used to show the prospects of Islamic financial system developmet in Central Asia and other Muslim populated territories. Such analysis may not be accurate in employing growth strategies due to its limited validity. The statistics of population of ethnic groups may show only the proportion of population having potential loyalty to Islamic financial tools. But it invalid indicator in predicting possible demand for shariah complied products. The terms cultural and practising

Muslims are often used in making distinction in religiosity. Cultural Muslims can be attracted mostly by the economic reasons rahter than religious ones. At this point of time when only Kazakhstan adopted legislation on Islamic financial instruments it is difficult for Islamic financial institutions to compete with conventional institutions. Especially the retail sector is more sensitive in terms of legal protection from state. It should be noted that the number of practising Muslims is steadily increasing. This trend can be seen in increasing supply of products with HALAL labeling, increasing number of mosques, and rise of Islamic media. The religional TV channel Asyl Arna was launched in 2009 in Kazakhstan. The business classifieds newspaper HalalPro contains the advertisements of companies producing halal products. The practising Muslims have higher loyalty to Islamic financial tools for religious reasons. However, the analysis of their knowledge about Islamic finance is very low in Kazakhstan. As the Kazakhstan is the flagman in introducing the new financial system, it is expected that in other Muslim populated countries and regions of post-Soviet area the situation concerning the knowledge about Islamic finance is not better of situation in Kazakhstan. The awareness of people in Kazakhstan about Islamic Finance In order to measure the awareness of Islamic financial instruments the survey was administered among the people registered on alhalal.kz web-site which publishes the list of companies that work under Halal certification of Kazakhstan Technical Comitee for Halal standardization. The survey was accomplished by sending link to the online questionnaire form to the 425 registered respondents. The response rate was 28% with the total number of respondents equal to 118. The percentage of respondents that perform daily prayers was 75% of total respondents. The Figure 1 indicates low level of knowledge about Islamic financial tools among respondents with more than half of them showing their disagreement and neutrality.

Figure 1. The attitude of respondent towards statement: I am well informed about Islamic financial tools The survey was udertaken to measure respondents atittudes towards halal products selection including the Islamic finanical tools. It is interesting to note that Muslims are very careful when choosing meat but less careful in choosing financial instruments. The Figure 2. shows that more Muslims are very careful in choosing meat and smaller percentage are careful in choosing financial products.

Figure 2. The respondents behavior in choosing meat and financial products. Another important factor that should be considered in analyzing the prospects of development of Islamic financial system on the post-Soviet area is the doing business culture. DOING BUSINESS CULTURE The modern histrory of entrepreneurship in post-Soviet area starts from early nineties after the collpase of Soviet Union. The 1990s are the turbulent times when the most of the newly independent countries faced dramatic economic decline. The highest decline was in manufacturing sector and countries became import dependent. The first signs of development were clear in the beginning of the new century. Russia, Kazakhstan, and Azerbaijan have higher growth rates due to availibility of natural resources. Turkmenistan also benefited from its Gas reserves. Trade and construction were major sectors that developed in tact with oil and gas industry. In case of Kazakhstan the economic growth was stimulated by increasing consumption through debt instruments. The availibility of consumer and mortgage loans have boosted trade and construction sectors. Companies in these sectors also were mainly financed through bank loans. The Figure 3 shows the loans provided for Small and Medium enterprises.

Figure 3. Loans amount provided by commercila banks to SMEs in Kazakhstan (billions)3

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Small Business Development Fund, www.damu.kz

The high reliance on debt financing was caused by limited availibilty of other sources of financing. Venture capital financing which is more similar to Profit Loss sharing agreements in Islamic finance is not widespread in Kazakhstan. The statistics of SME in Kazakstan for January 1, 2010 indicate that Sole Proprietorship is most popular form of business (62% of total)4. The feature of Sole Proprietorship under Kazakhstan civil code limits its ability to attract investors. Sole Proprietors rely only on their own capital and bank loans. The Head of Board of Directors of Kazyna Capital Management5 indicated the lack of projects for investors and low transparency of business (Zholdubekova, 2010). The problems with financial reporting and valuation of business were among problems indicated by the Venture Fund Manager. The transparency problem exists in all post-Soviet countries. During the Soviet time people tend to hide their buisness activities from public. The government and public opinion viewed any type of private business as speculation and it was tolerated only in a low scale. The lack of transparency limits the prospects of Islamic banking. Therefore, the development of Islamic Finance is seen in large infrastructural projects in most cases backed by governmnet. The first Islamic bank Al Hilal Bank established its branch in Kazakhstan on the 25th of March 2010. The bank plans to invest in public and corporate projects in first 12-18 month of operations. Financial services for Small and Business owners will be provided only after this period (Chomchokbayeva, 2010). The establishment of the second Islamic Bank is planned in 2011. This is the joint project of Malaysian Financial Group AmanahRaya, Development Bank of Kazakhstan, and Fattah Finance Group (Baimanov, 2010). THE LEGISLATIVE BARRIERS The legal framework has crucial role in development of Islamic Financial system. The implementation of certain interest-free tools is impossible in absense of legal framework. The Murabaha is impossible for implentation by banks under existing legislation of post-Soviet countries because banks are banned from investment activities except investments in precious metals and securities. Only Azerbaijan allows investment banks and Kauthar bank managed to introduce changes and has no credit portfolio. The credit agencies are also prohibited from trade and investment operations. Especially Russia has severe rules which made the operations of Badr-Forte Bank (the one of the first Islamic institution in Russia) impossible. It was closed for breaching the Federal law on confronting the money laundering and support of terrorism. Profit/Loss sharing agreements are possible only through creation of new Limited Liability Partnership. The compliance of its activities to shariah principles can not be legally controlled. The only limitation for shariah prohibited activities is mentioning this activities in the Charter of Limited Liability Partnership. Kazakhstan is the only country on post-Soviet area that adopted legislation that allows easier operation of the number of Islamic Financial tools. The law On Ammendments and Ammendums to Some Laws of the Republic of Kazakhstan Concerning the Establishment and
According to Kazakhstan State Statistical Agency Sole Proprietors are 62% of all SME in Kazakhstan, Legal Entities mostly in form of Limited Liability Partnerships 20% and Farms 18%.
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State owned Venture Capital

Operations of Islamic Banks and Financial Organizations was adopted on the 12th of December 2009. The law creates environment for Islamic banks to use murabaha and other tools. In a text of law the terms Murabaha is used as Commercial loan and this type of loan operations when the bank purchases ans sales assets are not subject to Value Added Tax6. The deposits in Islamic banks are not part of state deposit guarantee program. The term Musharaka is used as purchase of stocks or shares. The investments in tobacco, alcohol, weapon, and gambling business are prohibited by law. Other types of businesses prohibited by shariah are subject to the decision of Shariah council which is independent from bank. For Sukuk operations the law allows the establishment of Special Financial Company (SPV) but limits the list of possible originators by state companies. The Table 1. presents the analysis of legislation on Islamic Finance in Muslim populated countries on post-Soviet area. Only Kazakhstan has adopted legislation for full-pledged development of Islamic Financial tools. Kyrgyzstan government was also active in talking on adoption of legislation but recent political crisis limited the further developments. Azerbaijan is more close to adoption of legal framework for Islamic Financial tools. The Central Bank of Azerbaijan have made some steps towards changes in legislation but still in doubtful position. Russia federal government shows less interest in development of alternative system. However, Muslim populated republics such as Tatarstan are very active in introducing financial instruments that fit shariah principles. Table 1. Legal Framework for Islamic Financial System and trends in Muslim Populated countries on post-Soviet area (developed by author)
Country Kazakhstan Legal Framework The law On Ammendments and Ammendums to Some Laws of the Republic of Kazakhstan Concerning the Establishment and Operations of Islamic Banks and Financial Organizations adopted on the 12th of December 2009 Trends The Regional Financial Center of Almaty as public company is the initiator of developments in legislation. The media is full of welcoming articles on Islamic Finance. The recent crisis of conventional banking sustem also raised interest in alternative sources of financing. The official Baku is welcoming the development of Islamic Finance. However, there are also opposing forces that slow down the process of development of Islamic Financial tools. EcoIslamicBank was launched as the pilot project Special Legislation was adopted to support this project. However, this legislation is not applicable for other financial institutions. The discussions about adoption of legislation on Islamic Finance started in 2006 but were cancelled due to instability in Kyrgyzstan.

Azerbaijan

Kyrgyzstan

No special law but the Central Bank allowed changes in the Charter of some banks. Kauthar bank has no credit postfolio and opearates as investment bank. EcoIslamicBank launched in 2006 by Islamic Bank of Development and Government of Kyrgyzstan

Tax implemented in most of post-Soviet countries.

Uzbekistan

No special legislation for Islamic financial IDB invests in road construtction and institutions Islamic Corporation for Development of Private Sector (ICD) provides loans through Commercial Banks. Turkmenistan No special legislation for Islamic financial IDB participates in infrastructural projects. institutions There is no much discussion on adoption of legislation. Russia The financial institutions in Tatarstan Tatarstan government tries to have local provide some financial tools that are legislation on Islamic Banking. The federal possible within existing legal framework government shows very limited response towards adoption of federal legislation.

Concluding Remarks Among many lessons to be learned from recent economic crisis is that the speculative nature of traditional financial system creates vulnerable economic environment. The Financial system detached from real sector and served the interests of minor group of capitalists. The only alternative possible which has huge potential in supporting economic development based on real sector is the financial system based on shariah principles. This feature of Islamic Financial system attracted the leadership of Kazakhstan to adopt special legislation. The government plans to use capital of Islamic financial institution for industrial development of the country. This top down approach is supported by emerging practising Muslims community increasing awareness of shariah complied financial tools. The distinction between cultural and practising Muslims is made in a paper in order to provide better analysis of current situation with potential demand based on religious view. Doing business culture is another important factor influencing the development of Islamic financial system. The one of the reasons for concentration of capital from IDB and other financial institutions in government and corporate projects is the lack of transparency of SME in post-Soviet area. Moreover, the absense of legal framework for implementation of certain tools limits the development of shariah complied financial tools. Kyrgyzstan and Azerbaijan showed some progress towards improving legal framework. Russia federal government remains very conservative with only Tatarstan taking some initiatives towards creating better environment for Islamic financial system. The process of Islamic financial system development has already started on post-Soviet area. If the Islamic financial institutions in Kazakhstan show positive results and contribute to economic development of the country in upcoming years, other post-Soviet countries governments will catalyze the processes towards improvement of legal framework and will show great support. Therefore, Kazakhstan can be viewed as the pilot project. The success or failure of this project may significantly influence the attitudes towards Islamic finance on post-Soviet area. REFERENCES Ahmad, N., & Haron, S. (2002). PERCEPTIONS OF MALAYSIAN CORPORATE CUSTOMERS TOWARDS ISLAMIC BANKING PRODUCTS & SERVICES. International Journal of Islamic Financial Services .

Ainley, M., Mashayekhi, A., Hicks, R., Rahman, A., & Ravalia, A. (2007). Islamic Finance in the UK: Regulation and Challenges. Retrieved September 21, 2010, from official web-site of Financial Services Authority of UK: http://www.fsa.gov.uk/pubs/other/islamic_finance.pdf Baimanov, D. (2010, July 19). The Second Islamic Bank to be Established. Retrieved September 22, 2010, from KazInform: http://www.inform.kz/rus/article/2287498 Chomchokbayeva, D. (2010, June). Prasad Abrakham, Perspectives of Islamic Banking in Kazakhstan. Retrieved September 21, 2010, from BusinessWomenKZ: http://www.businesswomen.kz/archive/2010/22/1627.html Filatov, S., & Lunkin, R. (2005). Statistics of Russian Reliogisity. Sotsialnie Issledovaniya, (6), pp. 1-19. Haron, S., Ahmad, N., & Planisek, S. L. (1994). Bank Patronage Factors of Muslim and nonMuslim Customers. International Journal of Bank Marketing, (12), pp. 32-40. Kaariainen, K., & Furman, D. (1999). Tatars and Russians - Beilievers and unbeleivers, Old and Young. Voprosy Filosofii , (11), pp. 68-80. Wilkes, R. E., Burnett, J. J., & Howell, R. D. (1986). On the Meaning and Measurement of Religiosity in Consumer Research. Journal of the Academy of Marketing Science , (14) pp. 4756. Zholdubekova, G. (2010, October 22). The industry of Venture Capital is in stage of Development. Business and Government , pp. 21-22.