As a way to offset Western financial sanctions, Russia is interested in attracting tens of billions of dollars from the United Arab Emirates, Malaysia, Indonesia and other rich, predominantly Muslim states, and becoming a new center for Islamic finance. Will it succeed?

Emirati traders check the stocks of Emaar Malls on the screen at the Dubai Financial Market in United Arab Emirates, Thursday, Oct. 2, 2014. Photo: AP

Russia’s economy has been losing ground globally ever since the European Union imposed economic sanctions on the country following its aggressive behavior in Ukraine. Falling oil prices, the depreciation of the ruble, and the downgrade of Russia’s debt to junk status by Moody’s and Standard and Poor’s (S&P) have forced the Russian authorities to look for alternative sources of funding. Accordingly, a draft law facilitating the establishment of Islamic finance in the country was introduced to the State Duma last week.

The process seems to be moving remarkably fast, especially for the Russian bureaucratic system. In the summer of 2014, Russian banks lobbied Moscow’s central bank to enable sharia-compliant financial institutions to enter the Russian market. In December, Russia's National Rating and the Islamic International Rating Agency entered an agreement to jointly rate sharia-compliant products. By March of this year, the State Duma Committee on Financial Markets was already hosting a meeting with the representatives of the embassies of Egypt and Iran, various banks and financial institutions, as well as national monetary authorities.

In an interview for Bloomberg in February, Anatoly Aksakov, the president of the Association of Regional Banks of Russia and a deputy in the Duma, stated that Russia is interested in attracting “tens of billions of dollars” from Malaysia and Indonesia, as well as the United Arab Emirates and other, rather vaguely defined, “Arab states.”

Arguably, in order to do that Russia – especially following its downgrade by S&P’s and Moody’s – might be most interested in an instrument named sukuk, a sharia-compliant financial certificate commonly known as an Islamic bond. Sukuk can be structured in a number of ways, the most convenient of which in Russia’s case would be sukuk al-ijara; an asset-based certificate based on the al-ijara financial scheme, which is very similar to an agreement we know in the West as “leasing.”

The sukuk al-ijara are attached to asset-based instruments issued by the lessor for investors, and so it is the quality of those assets rather than Russia’s international ratings that determine the attractiveness of the sukuk. Moreover, unlike debt-based sukuk, this particular type is tradable and can be listed on a stock exchange.

Numerous obstacles stand in Russia’s way to becoming the regional hub for Islamic finance, though. Lack of appropriate legislation is the first one. As of right now, the federal law “On Banks and Banking Activities” prohibits banks from any kind of industrial and commercial activities.

However, a number of Islamic financial instruments require that banks act as intermediaries between clients and private businesses, for example while buying real estate property or a car that would be later re-sold to a client within an ijara or murabaha (mark-up sale) scheme. What is more, double- or even triple-taxation might be incurred by some schemes. For example, the most popular sharia-compliant instrument – the above-mentioned murabaha, which involves more than one transfer of the underlying assets, might face multiple points of taxation.

Additional difficulties are brought by the lack of one common set of international standards that all sharia-compliant financial institutions would follow. Islamic instruments are structured based on various interpretations of Islamic law, the choice of which is largely dependent on the institution’s home country.

If Russia indeed, as Mr. Aksakov claims, wants to attract halal money both from Arab states, as well as Malaysia and Indonesia, they will have to think about solutions to this diversity of Islamic law. It is quite likely that, due to the variety of interpretations of these tenets, not just across countries but also within them, the Bahrain-based Islamic International Rating Agency might not certify many Malaysian or Indonesian instruments, simply because they may be created in accordance to a different (shafi’i) interpretation of sharia.

External factors also complicate Russia’s drive to become an Islamic finance hub. Russia’s biggest competitor in the quest to attract halal money will be United Kingdom, Europe’s biggest center for Islamic finance with 19 billion pound sterling (GBP) of reported sharia-compliant assets.

The UK also just recently (in June 2014) issued the first sovereign sukuk of 200 million GBP, in the process becoming the first country outside of the Islamic world to do so. This milestone did not come easy, however, as British lawmakers managed to remove double taxation and extend tax relief on Islamic mortgages to both companies and individuals only in 2003 – 21 years after the first Islamic bank, Al Barakara International, opened in the country.

With the appropriate legislation already in place, easier procedures and many years of intense PR work, as well as a stable political situation, the UK seems to be a much more attractive place for Islamic investors than Russia. If the Kremlin is truly interested in attracting halal money, it may want to focus on stabilizing the economy and adjusting its financial laws.

Of course, attracting Islamic banks will not heal the economy on its own - even if Russia managed to issue the same sukuk worth 200 million GBP that the UK did, it would just be a drop in the ocean of Russia’s growing needs. It might, however, be a good start in an attempt to capture a new market while old ones are experiencing difficulties. The path that the UK took may serve as a good example for Russia, but it also counsels that Russians must have patience as well.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.