Iran and the Islamic Finance Crown

By Jacopo Dettoni

June 16, 2015

http://thediplomat.com/2015/06/iran-and-the-islamic-finance-crown/

Could an Iranian financial comeback challenge Sunni dominance of global Islamic finance? 

Iran is one of the pioneers of Islamic finance. In 1983, four years after the revolution led by Ayatollah Khomeini overthrew the Shah, the Islamic government passed the Riba-Free Banking Act, forcing local banks to rebuild their business around sharia-compliant products.

More than 30 years on, the Iranian banking industry remains completely regulated by sharia law and is by far the world’s largest center of Islamic banking. Yet its experience is unique within the global Islamic community, as it is inspired by Shia jurisprudence, which often diverges from mainstream Sunni jurisprudence. Sunni scholars have repeatedly questioned the “rightfulness” of Iranian banks, with some even claiming that they “are merely carrying Islamic labels and are rather dummy version [sic] of Islamic banks,” to put it in the words of a paper published by the International Islamic University of Malaysia (IIUM).

However, with Iran now seemingly closer than ever to an agreement with the West over its controversial nuclear development program, local financial institutions are poised to regain access to international markets and place their sharia-compliant products among emerging market enthusiasts. Yet instead of adding new momentum to the growing Islamic finance industry, Iran’s financial comeback risks opening a new chapter in the century-old clash of principles between Sunni and Shia Islam.

“[Should an agreement with the West really happen] Iran will still remain segregated, because its concept of Islamic finance is not exactly similar to the concept of Islamic finance in other Muslim countries,” Monzer Kahf, a sharia scholar and professor of Islamic finance and economics at the Qatar Faculty of Islamic Studies, told The Diplomat. “This is the result of an intellectual position adopted in Iran which may not be accepted in other countries.”

Islamic finance forbids the use of a pre-determined fixed interest rate, also known as riba, in banking and financial transactions, as well as investing in businesses that provide goods or services considered contrary to its principles. Financial interests are not banned altogether; they are accepted as long as they represent a ratio of the profit generated by the use of capital. Riba-free banking thus translates in contracts like mudaraba,which literally identifies a profit-sharing agreement between the bank and its clients, either in the form of deposits or loans.

Although Islamic finance practices were first developed in the Caliphate between the 8th and 12th centuries, they gained new momentum in the late 20th century, when countries like Saudi Arabia accumulated huge amounts of petrodollars and began focusing on how to make their booming financial sectors comply with the teachings of the Quran. Over the last 20 years, the development of the Islamic finance industry has accelerated. Global Islamic banking assets stood at roughly $1,560 billion by the end of 2014, according to figures from the Islamic Financial Service Board (IFSB). At the same time, outstanding sukuks, or Islamic bonds, grew by an annual 20.7 percent between 2008 and 2013, amounting to $294.7 billion at the end of September 2014, IFSB figures show. Both Islamic banking and bond assets are expected to continue growing at double-digit rates in the coming years, as estimated by international observers such as consultancy firm Deloitte and credit rating agency Moody’s.

End of Isolation?

Iran, the only Muslim country besides Sudan where the entire financial industry is obliged to be consistent with the principles of sharia law, accounts for more than 40 percent of the world’s total Islamic banking assets. Trailing far behind is Saudi Arabia with 18.5 percent, Malaysia with 9.56 percent, and the UAE with 7.36 percent. However, years of isolation have prevented its bonds from reaching the international markets, leaving the leadership of the global sukuk market to Saudi Arabia, and above all, Malaysia. Things may be approaching a turning point as the Islamic Republic and the P5+1 group (China, France, Russia, the United Kingdom, the United States plus Germany) appear closer than ever to a deal over Iran’s nuclear development program. A deal would trigger a gradual removal of Western sanctions and reinstate Iran as a legitimate member of the global financial community.

“This Iranian government led by Hassan Rohuani is very keen to integrate the country into the global economy,” Ishrat Hussain, former governor of the Central Bank of Pakistan, told The Diplomat. “They have to catch up with the rest of the world. Now that the sanctions may be over, the government and the private sector have to do lot to rebuild the economy.”

Cash-strapped Iranian state and private companies are keen to tap the international debt market and address the shortage of hard currency they are facing as a result of years of crippling international sanctions. About 180 companies are considering Islamic bond sales in 2016, a Bloomberg report noted in April, quoting estimates from a local financial analyst. Foreign investors will be equally keen to chip in given Iran’s economic potential based on its massive hydrocarbons resources and a domestic market of 77 million people. Iran featured among Goldman Sachs’ “Next 11” most promising countries in 2007, before a new round of Western sanctions dragged down the entire economy.

Iranian bonds and other financial instruments will not be an easy bet for Sunni asset managers though.

“In Iran, whatever the vali-e faghih-e iran [the supreme leader Ayatollah Khamenei, who succeeded to Khomeini in 1989], or whatever the Islamic government approves in his name, is to be considered Islamic,” Kahf says. Iran is home of the world’s largest Shia community, with Shiites representing 95 percent of the country’s population. Shiites are estimated to make up 10 percent to 20 percent of the world’s Muslim population, the remainder being Sunnis.

“On the other hand, in Sunni countries, we rely more on the sharia law as understood by the four classical school of thought of the Sunni tradition, which represent the basement for any opinion on Islamic finance. […] This means that whatever is called Islamic finance in Iran most likely is not acceptable as Islamic finance outside Iran. As a consequence, a sukuk issued in Iran will not be able to get customers in Sunni countries such as Qatar, Malaysia or Pakistan and the other way round.

Apart from the different jurisprudential approach, Iranian banks have also been questioned over their real commitment to comply with local Sharia rules.

“It seems that many of activities which are common practice in the Iranian banks are just alike commercial banks,” the IIUM paper reads.

“After enacting the riba-free banking services in 1983, neither customers nor banks could implement the Ughods [Islamic principles].”

Years of isolation and a different approach to Islamic finance have left Iran at the margins of the growing global Islamic finance industry. Even the fact that the country may be close to staging a financial comeback went largely unnoticed at the last Islamic Financial Service Board (IFSB) summit, one of the most important events on the annual calendar of the Islamic finance industry, held in Almaty, Kazakhstan, in May. Saudi Arabia, Malaysia, and the UAE shared the spotlight as the industry’s trendsetters while Indonesia and Turkey were repeatedly pointed out as its next big thing, although Sharia-compliant assets remain just a (growing) fraction of total assets in both countries. Only a handful of delegates represented Iran.

“Unfortunately, the Iranian banking system has so far failed to maintain a constructive cooperation with pioneer countries in the field of Islamic banking,” Farhad Nili, head of the Monetary and Banking research institute within the Central Bank of Iran, wrote in a 2014 research report. “Hence the international community knows little about the theoretical foundations and practice of riba-free banking in Iran.”

Other Iranian officials tend to downplay the existing differences between Iran and other major Islamic finance centers and focus on the financial appeal of Iranian products instead.

“It’s like buying a smartphone, there is no Shia or Sunni smartphone, it’s just the same,” Mohammad Fetanat, chairman of Iranian market regulator Security and Exchange Organization (SEO), told The Diplomat on the sidelines of the IFSB summit.

“In terms of profits, Iran is one of the [most] profitable countries in the world. Mid-term yields on bonds and deposits range between 20 percent to 30 percent in local currency, and many of these returns are adjusted to inflation and foreign exchange variations.”

Iran and the P5+1 have time until June 30 to follow up on the framework agreement they announced on April 2. Iranian financial authorities and institutions are already gearing up to stage their comeback in the international financial community. The SEO itself is working at a conference — to be held in Tehran in September – specifically aimed at attracting foreign investors into the Iranian capital market. It can lure Western investors with attractive returns, but they will need much more to convince their fellow members of the Islamic community that, at the end of the day, a Shia sukuk is just like a Sunni sukuk.

Jacopo Dettoni writes on business and current affairs.