25 June 2022

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ALTERNATIVE INVESTMENT TOOL

Laws on the norms of Islamic finance in Azerbaijan to expand capital inflow from wealthy Muslim countries

Author:

15.11.2021

The banking and financial community of Azerbaijan has been repeatedly requested to get actively engaged in the introduction of Islamic banking in the country. First, there is an internal potential, or popular demand associated with the religious beliefs of citizens, who refuse to use traditional banking products. Secondly, it would make it possible to diversify the sources of investment and enter new capital markets. Experts believe that, given the development and stability of financial and banking sectors in Azerbaijan, it can well become a hub of Islamic finance in the post-Soviet space.

Despite these arguments, the legal basis for this activity is yet to be approved. Recently there have been active discussions on this issue, particularly on the issue of the imminent use of a financial tool known as sukuk, which is a Shariah-compliant type of bonds.

 

Emerging market

For several years, financial experts have been speculating that the development of Islamic banking would benefit the banking system of Azerbaijan. In fact, the Shariah-compliant financial institutions become increasingly powerful in the world and can act as investors in large projects. Therefore, they need similarly effective partners in the country of operation.

Islamic banking is an alternative to traditional banking through the prohibition of lending interest, increased risks, and uncertainties. In addition, it prohibits investing and receiving income from activities prohibited in the Shariah. In fact, the Islamic financial system uses the same tools as the conventional one, but it replaces the interest in credit relations by a certain share, that is a profit in the company. This way the lending institution (bank) shares all the risks with the borrower.

But it is wrong to think that these tools are used only on the Arabian Peninsula or the Muslim world. It is known that many countries that adopted the Shariah laws have fairly rich economies, and act as profitable partners for attracting investment. Eventually, this could not but encourage European investors known for their enterprising character and the first Islamic bank appeared in Europe back in 1978 in Luxembourg. Currently Citibank, HSBC, JP Morgan, Goldman Sachs, Credit Suisse and many other giants of the banking sector have branches providing services in Islamic financing. In Britain, 20 of the country's 150 banks provide financial services under the Shariah laws. Transnational companies, including General Motors, IBM, Alcatel, and Daewoo benefit from the services of Islamic banks.

Their financial instruments are also very popular among Azerbaijan's neighbours, not only in Iran. In Turkey, one of the largest state-owned banks of the country, Ziraat Bank, opened its first branch in Istanbul this year, which will provide services in line with the principles of Islamic banking.

According to President Recep Tayyip Erdogan, “Islamic banking in Turkey now accounts for 5% of the total turnover of banks. Its share should increase to 20% by 2023 ”. Before the opening of the Islamic branch of Ziraat Bank, four Islamic banks operated in Turkey.

In general, according to the pre-pandemic data for 2019, the size of global Islamic financial market reached $2.2 trillion, having expanded by 7% over the year. The number of commercial Islamic banks was 418. According to Ernst&Young, although Islamic banking only manages a fraction of Muslim banking assets, it is growing faster than banking assets as a whole. The total volume of global financial assets of the Islamic financial sector is about $2.88 trillion. This indicator is expected to reach $3.69 trillion by 2024.

 

Equal competitive opportunities

Given the global trend, we can assume that the legal regulation of Islamic banking will be introduced in Azerbaijan soon, despite the long resistance and mild opposition from regulators and the traditional banking community.

Back in January 2017, Azerbaijan signed a grant agreement with the Islamic Development Bank, which provided $200,000 as technical assistance for the implementation of this mechanism in Azerbaijan. At the same time, the State Agency for the Development of Small and Medium Businesses (KOBIA) was appointed responsible for the implementation of the project dealing with the provision of technical support to the preparation of legal basis of Islamic banking in Azerbaijan. Ekvita Consulting consortium was selected to prepare proposals for the implementation of this system.

The consultant has already completed its part of the project and submitted proposals to the government, which should legislatively expand the possibilities of Islamic finance in the country.

What is the essence of these proposals? According to the head of Ekvita Consulting, Ilgar Mehdi, it is necessary to create a system in Azerbaijan that could stimulate the development of Islamic banking. After all, the current legislative framework is built purely on traditional banking. Islamic banking allows making profit by directly participating in the business, while according to the current legislation, banks cannot operate in the non-financial sector. Therefore, the legal framework should be revised to remove this prohibition. This is not about granting any privileges to the Shariah-compliant banks. I. Mehdi noted that the goal of these changes is to create equal conditions for all types of banking activities.

Thus, a project was developed so that it ensures equal competitive opportunities for all banks from a legal point of view.

The operation of Islamic banks also requires the settlement of tax issues. According to the Tax Code of Azerbaijan, buying and selling assets is not exempt from value added tax (VAT).

According to the standards of Islamic banking, a bank buys an asset and then sells it to a client in installments. In this case, VAT is applied to both sale and purchase of the assets. That’s why one of the proposals is to eliminate double taxation.

In parallel, the Shariah-compliant banks must be approved by the religious council, which includes specialists from the financial sector, as well as individuals knowledgable in Islamic banking. Moreover, there is no prerequisite for members of the council to be Muslims. For example, the most famous specialist on Islamic banking in London is Jewish.

Why is a religious council necessary to provide financial services? According to the consultant, the council must check and approve the compliance of banking products with the principles of Islamic banking, which is very important for religious clients. I. Mehdi believes that in Azerbaijan there are difficulties with the construction of such a system because of the issue of different confessions. In addition, members of the council must be financial experts, which are very few in Azerbaijan...

 

National sukuk

Other CIS countries, particularly Russia and Kazakhstan already appreciate the benefits of products provided through Islamic banking. Given the development and stability of financial and banking sectors in Azerbaijan, it could well become a hub of Islamic finance in the post-Soviet space.

Presently, the development of Islamic banking instruments is limited by the law on banks, although a few years ago a number of local banks offered products that did not contradict the legislative acts regulating their activities. Today, initiatives in this direction have been completely reduced to zero. Yet the state-owned enterprises show a considerable interest.

State-run member companies of the Azerbaijan Investment Holding are preparing to issue sukuk (Islamic equivalent of ordinary bonds).

The holding intends to cooperate with the Islamic Corporation for the Development of Private Sector (ICD), which is a division of the Islamic Development Bank Group. Parties have already signed a Memorandum of Understanding.

AzerGold CJSC also signed a Memorandum of Understanding with ICD. One of the goals is to study the possibilities of issuing sukuk to meet the growing demand of AzerGold for financing projects.

New financial sources will appear in Azerbaijan with the issue of Islamic bonds. Indeed, there are enough people in Azerbaijan who do not buy bonds, considering them haram (prohibited by Islam). On the other hand, in Gulf countries of Qatar, the UAE, Kuwait, Bahrain there are enough investors interested in investing in Azerbaijan. But they do not do it for the same reason. The issue of sukuk will in a short time provide an inflow of large funds to the companies managed by the Azerbaijan Investment Holding.

It is expected that there will be high interest in Islamic bonds, since they provide significantly higher profit than traditional securities, where the profit is calculated at a fixed interest rate and regardless of the outcome, the ultimate income is provided through interest. In sukuk, the company's net profit is divided and the investor also shares the risks. It may seem that sukuk is a more risky investment than traditional bonds, but in reality it is not. In international practice, there are mechanisms to minimise the risks of sukuk in various ways.

But since the profitability of sukuk depends on the outcome, in some cases it is significantly higher than that of traditional bonds. Therefore, this investment tool is used not only by Muslims, but also by non-Muslims.

Meanwhile, introduction of sukuk in Azerbaijan may lead to some inconsistencies with the legislation, that is double taxation. In other words, sukuk can be taxed as a bond because of interest income, as well as because of the dividends it brings from profits. To increase the attractiveness of sukuk, it will be necessary to amend the tax and civil codes of Azerbaijan.

The head of the Capital Market Supervision Department of the Central Bank of Azerbaijan, Samir Ismayilov, also considers it necessary to introduce certain amendments to the legislation in order to form a regulatory framework for the introduction of sukuk.

Apparently, these reforms will not take long to be introduced given the interest the Azerbaijan Investment Holding, hence the government in Islamic financing.

This is also confirmed by the conference Sukuk: Alternative Financing Mechanism in Azerbaijan organised by the Centre for Analysis of Economic Reforms and Communications and KOBIA in partnership with ICD.

The purpose of the event was to promote sukuk in Azerbaijan. Participants also discussed the possibility of using sukuk as an alternative funding mechanism in infrastructure projects and public-private partnership projects in Azerbaijan.

Experts believe that this will ensure the country's economic security, as the more sources and forms of financing the investment projects, the better. Islamic finance can become one of the possible corridors taking Azerbaijan to new markets. As a result, the country can get an inflow of funds that will help develop the economy of the entire region.



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