Clare Nuttall in Almaty -

After a lengthy delay, the government is on track to issue Kazakhstan's first sovereign sukuk, or Islamic bond, before the end of this year - a key step in the country's desire to become a regional financial hub, says Arken Arystanov, head of the Regional Financial Centre of Almaty City (RFCA).

Amendments to Kazakhstan's law on Islamic finance and banking, currently being considered by parliament, are due to be adopted within the next two months, Arystanov says, paving the way for the government to issue its debut sukuk - most likely in the $500m range - by the end of 2010.

The original law on Islamic finance was adopted in February 2009 as part of Kazakhstan's drive to turn the former capital Almaty into a financial centre for Central Asia and the wider region. At that time, the Kazakh government was also keen to tap Middle Eastern and other Islamic markets for money - the country's image had been tarnished by the near collapse of the banking sector and the nationalisation of BTA Bank and Alliance Bank, and was having a hard time accessing funds from developed markets struggling to cope with the economic crisis.

But while President Nursultan Nazarbayev has been a driving force behind the introduction of Islamic finance, there is another school of thought in Astana that believes with the reopening of traditional international capital markets, the rationale for an Islamic offering is less valid than previously. "Because of the crisis, western money did not come to us, so we had to find an alternative. After one year, the money markets have opened again and now the Finance Ministry says we no longer need to issue a sukuk," Arystanov tells bne.

It's certainly true that for some Kazakh companies there has been no difficulty in raising money by traditional means recently. State nuclear company Kazatomprom's debut Eurobond in May 2010 was eight times oversubscribed; the issue by national rail operator Kazakhstan Temir Zholy in September was seven times oversubscribed. "This means that Kazakhstan is very hot and these issues were welcome to western investors," admits Arystanov.

However, he believes a sukuk is still important. "This is a strategic question. We understand that issuing a Eurobond is the easiest way, and the price of the two options is similar. But we think we should diversify our funding sources to encompass both Eurobonds and Islamic bonds. A sovereign sukuk will help to raise our profile in the Islamic world and set a benchmark for future corporate issues," he says. "We didn't develop Islamic finance just for one year; it's a long-term strategy. The aim is that by 2020, Almaty will be the centre for Islamic finance in the CIS region."

Tweaking the law

Further changes to the law are in the works. It was a deliberate policy on the part of the Kazakh authorities to push through the legislation and encourage Islamic finance players to enter the market, rather than allow discussions over how the law should be structured to drag on. This has paid off so far, with United Arab Emirates-based Al Hilal Bank announcing plans to enter the market in March 2009 - just one month after the legislation was adopted. "We passed a general law, then the first bank - Al Hilal Bank - came to Kazakhstan, and we are now involved in day-to-day discussions with Al Hilal over how to improve legislation. Before we passed the law, lots of foreign specialists gave their opinions on how the law should be structured. We said to them - come here and set up operations in Kazakhstan, then we will listen to your requirements!" Arystanov explains.

Some of the issues that Al Hilal has raised with the RFCA include the need to sign a murabaha (Sharia-compliant sale) agreement with the Central Bank of Kazakhstan and legislation on takaful ( Sharia-compliant insurance) - a prerequisite for corporate bond issues. Regulation of the new sector is another topic of discussion.

Despite the need for new legislation, other international banks offering Islamic finance have also shown an interest in entering the Kazakh market. Islamic brokerage Fattah Finance was set up immediately after the law was adopted, and Kazakhstan already has a local Haj fund, which allows people to save toward making a pilgrimage to Mecca. The Malaysian government, the Development Bank of Kazakhstan and Fattah are planning to set up the country's second Islamic bank. The third is set to be Kuveyt Turk Bank, which after 21 years of experience in Turkey obtained a banking license in Germany, and has now set up a representative office in Kazakhstan.

Arystanov is particularly keen to amend the law to allow Islamic windows in traditional commercial banks. He cites the example of Malaysia, where the Islamic banking sector suddenly expanded to 20 times its previous size in a single year after Islamic windows were introduced. Islamic windows are also used by HSBC, which has a growing presence in Kazakhstan, in the UK.

Al Hilal has seen considerable demand in the six months since it set up in Kazakhstan, especially from the retail sector, since it is still difficult to obtain consumer loans from local banks and high interest rates are charged. On the corporate side, interest has reportedly been mainly from small producers of halal meats and other foods, and trading companies.

Although the majority of Kazakhstan's population are nominally Muslims, few are strictly religious. "People in Kazakhstan tend to be very pragmatic. They make decisions for economic reasons - if it fits with their religion too, then that's a bonus," says Arystanov.

Historically, the country has had stronger links to Russia, the US, Europe, China and South Korea. However, relations with the Islamic world have been growing, and conversely Islamic financial centres have shown a greater interest in, for example, Russia and Kazakhstan in the last decade. "They are looking at countries with oil and gas, land and agricultural resources - Kazakhstan fits the profile perfectly," says Arystanov.

Within the CIS region, Kazakhstan is by no means the only country where there is an interest in Islamic finance, but considerably further along the road than its neighbours. Kyrgyzstan has one Islamic bank, Ecobank, but due to the country's small economy and recent political instability, its operations are on a small scale. Azerbaijan has the financial resources, but not the political will or the know-how. Russia, with some 40m Muslims - more than twice Kazakhstan's population - has not yet adopted a law on Islamic finance. This fuels Arystanov's hope that Kazakhstan's rapid entry to the sector will allow it to find a role as the regional hub for Islamic finance.