Rachel Morarjee in Moscow -

Officials meeting in the shadow of the snowy towers of Kazan's 16th century white Kremlin are in an unlikely site for hatching groundbreaking financial plans. But Kazan in Russia's Tatarstan region aims to be the first place in Russia to launch an Islamic bond, with a planned $100m-200m sukuk issue planned for July this year that will be a test case for the appetite for Islamic financial products in Russia.

Countries ranging from France and the UK, Thailand to Brazil are all exploring how to use Islamic financial investment to draw gulf petrodollars into their economies. The Islamic finance industry has boomed in recent years, growing at a rate of over 14% per annum from around $150bn since the 1990s to a total of $14.1 trillion in 2009, according to Jamelah Jamaluddin, CEO of Kuwait Finance House in Malaysia. The growth is to "serve over a billion people who have previously been underserviced," by the financial industry, she notes.

Russia is well placed in many ways to attract Islamic investment, say experts. "We strongly believe it is just a matter of time for Russia to catch up with the global market for Islamic finance," says Zaid Maleh, director of Investment Banking for Middle East and Africa at VTB Capital, the investment business of Russia's VTB Group.

Russia is rich in themes that are sharia compliant such as infrastructure, agriculture, Maleh notes, adding that there is an estimated $800bn pool of Islamic cash waiting to be tapped according to estimates from Bloomberg and Moody's Investors Service.

Linar Yakupov, chairman of the committee for small and medium-sized business in Tatarstan, says the region is trying to diversify its economy away from its traditional reliance on natural resources and attract more foreign investment. "Islamic finance is one of the alternatives to natural resources. It's an extra option us because we have a big Muslim population," he adds.

But a Muslim population is not the only prerequisite for countries aiming to launch Islamic financial products to attract petrodollars from the Gulf States.

Challenges

Tatastan's bond issue, which was earlier slated to be issued in March, was delayed by the legal and financial complexities of launching an Islamic financial product in Russia, highlighting the hurdles that will have to be vaulted for a local Islamic finance industry to take off.

The biggest challenge for Russia is to educate customers about shariah law, says Mohammad Farrukh Raza, managing director of UK-based Islamic Finance Advisory and Assurance Service (IFAAS).

Under Islamic law, banks are not allowed to charge interest, so bonds must pay investors using profit-sharing payments similar to dividends or use leasing transactions with purchase options, and must also be seen to fund investments with a social good beyond pure unfettered return. Investment in gambling, arms trading and alcohol are all banned under sharia. "If the lender wants to take part in the profit, he must also bear some of the risk. If there is no risk, then the lender is simply getting interest and runs contrary to sharia," says Abas Bin Abd Jalil of AmanahRaya Capital Group in Malaysia, which is a trustee of $30bn of assets and manages more than $2.2bn of private and listed entities."There are 10m-20m muslims in Russia and there is an opportunity to tap cross-border trade with Middle Eastern trade - state and federal Russian governments should start thinking about it."

However, the language barrier in Russia is a formidable hurdle for the industry's development because Russia has a shortage of scholars who are conversant in sharia law and well versed in structured financial products like sukuk bonds.

Other countries, such as France, have also faced this problem, but in Russia it is particularly severe in the aftermath of Soviet rule. "Human capital remains a great challenge for the industry, because there are not enough scholars to understand every part of the sharia law," Maleh from VTB Capital.

Since there are four different schools of sharia law, Russian bond issuers will have to think about which interpretation of the law to use to underpin their bond structure. "In the Russian case, you want to find an equilibrium. You don't want Russia to be limited to a narrow band of investors, but to appeal to investors in the Middle East where the most money is, but who more conservative," says Maleh.

Tax structures have proved an obstacle for Islamic finance in other jurisdictions such as France because if sukuk bonds are taxed in the same way as corporate profits, they cannot compete with traditional bonds for investors.

Adalet Dzabiev, general director of Moscow-based Al Shams Capital Group sounds a further cautionary note for Russia: corruption. "Russian corruption inhibits investment. There is little trust in Russian courts. Whether an investment is Islamic or not, there is little protection of the right of ownership under Russian law or confidence it the Russian courts," he says.

Tatarstan's bond issue this summer will prove a litmus test for Islamic finance, and show whether Russian banks can tap investors in the Gulf with innovative new products, or whether the cultural hurdles will be too great.