Fundamental issues will likely keep the Islamic finance sector’s market penetration in Kazakhstan low over the next few years, according to a commentary from Fitch Ratings.

There are only two Islamic banks in Kazakhstan (including Al Hilal Islamic Bank JSC: ‘BBB+’/Stable). They have limited product offerings and distribution channels and this creates supply-side constraints, the ratings agency said, noting that sukuk issuance in the Central Asian country was “embryonic”.

In May, Fitch rated the Islamic Corporation for the Development of the Private Sector’s proposed tenge-denominated sukuk ‘A+’.

Said Fitch: “Despite being a Muslim-majority country, there is low demand for Islamic products due to limited public awareness, sharia-sensitivity and confidence in the sharia-compliance of products. The government has, in the past, supported the industry through regulatory changes to diversify its financial sector, and aimed for Kazakhstan to become the Islamic finance hub of Central Asia. However, the industry hasn’t kept up pace, with more push and regulatory changes still needed.”

Islamic banks had a 0.2% domestic market share in Kazakhstan at end-1Q23, based on reported total assets, Fitch said. In neighbouring Kyrgyzstan, the domestic market share was higher, at 1.5%, it added.

The Kazakh government is aiming for the Islamic finance industry’s market share to reach up to 3%–5% by 2025, as part of its 2020–2025 Master Plan for Islamic Finance Development, the ratings firm said. “The conventional debt capital markets in Kazakhstan are also underdeveloped, although the sukuk market is even more behind, with only one issuance so far, in 2012,” it added.

Issuing sukuk is more complex and time-consuming than bonds, with issuance hindered by the regulations in Kazakhstan that require actual transfer of ownership of underlying sukuk assets to an Islamic special-purpose vehicle (asset-backed sukuk) rather than beneficial transfer of ownership (asset-based sukuk), observed Fitch, adding that this could incur additional charges, administrative hurdles and delays.

The Kazakhstani Deposit Guarantee Fund does not guarantee Islamic banks’ customer deposits, making them less attractive than conventional banks.

“There are also issues with tax-neutrality, a lack of sharia-compliant government securities, sukuk, Islamic liquidity-management products, and a dearth of qualified Islamic finance professionals. There also appears to be a lack of interest from larger conventional banks to tap into the Islamic segment. Regulations prevent conventional banks from opening Islamic windows,” Fitch said.

Islamic multilateral institutions have supported the industry’s growth. The Islamic Development Bank (IsDB) Group has a regional hub in Kazakhstan, with $1.7bn total funding for the country and 56 finished projects.

Concluded Fitch: “The Islamic finance industry in Commonwealth of Independent States (CIS) countries is still in its early stage of development. A push for financial inclusion could support the industry. About 19% of Kazakhstan’s adult population didn’t have a bank account in 2021, with 5% of the adults citing religious reasons, according to World Bank.

“Under Kazakhstan’s banking regulations, Islamic banks may contractually impose losses on Islamic investment deposits in case of underperformance of the funded asset. However, Islamic banks are unlikely to impose losses on depositors due to high reputational risk, which may lead to customer deposit outflows.”

Finally, Fitch pointed to how the accounting treatment for Islamic banks differs from conventional banks in Kazakhstan.

“Islamic investment deposits and assets funded from investment deposits are recorded off-balance-sheet, unlike in most markets,” it said. “Off-balance Islamic receivables have zero risk-weightings, and Islamic banks’ reported capital ratios receive an uplift compared to conventional banks, which allows them to grow faster with fewer capital constraints.

“Islamic banks report under the accounting standards issued by Accounting and Auditing Organization for Islamic Financial Institutions. Islamic finance is one of the key pillars of the Astana International Financial Centre (AIFC), and there is a Central Shari’ah Advisory Board in AIFC. In 2020, the Astana International Exchange (AIX) cross-listed sukuk for the first time, issued by Qatar International Islamic Bank. In 2022, sukuk issued by IsDB were also cross-listed on AIX.”