BAKU/TBILISI (Reuters) - When a businessman in Muslim-majority Azerbaijan wanted a bank loan that complied with Islamic principles, until a few years ago he had to negotiate it under the table.
The government's fear of political Islam forced banks to conduct "guerrilla Islamic finance" in which sharia-compliant deals were hidden under the appearance of conventional banking, says Fuad Aliyev, a scholar at Johns Hopkins University's Central Asia-Caucasus Institute in Washington DC.
Now several banks in Azerbaijan openly offer a limited range of services based on Islamic principles including bans on interest and pure monetary speculation. The country's largest bank, majority-owned by the state, has opened an "Islamic window" providing finance to small companies.
Yet the government of the former Soviet state has remained reluctant to take a key step: creating a law to regulate the industry, which could allow commercial banks to expand their operations and issue sukuk or Islamic bonds.
Islamic finance was born in its modern form in the 1970s, catering mainly to Muslims in the Gulf and southeast Asia. Over the past decade its growth has accelerated as economies in those regions have boomed.
Its slow, incomplete growth in Azerbaijan, where an estimated 93 percent of the 9 million people are Muslim, reflects fear that Islamic finance could encourage Islamist politics, bankers and analysts say.
But the government of President Ilham Aliyev cannot ignore the opportunity to cater for Gulf investors to the south.
"If a regulatory framework is developed and if Islamic finance is included into curricula (of local universities), there will be huge development of the industry in Azerbaijan," said Mahir Humbatov, an expert in Islamic banking at the Centre for Strategic Studies in Baku.
After Azerbaijan emerged from the wreckage of the Soviet Union two decades ago, it quickly joined the Islamic Development Bank (IDB), a Jeddah-based institution with a membership of Muslim nations, and has received over $1.2 billion in funding from the bank, spending most of it on infrastructure projects.
But until the last couple of years, the government did not want a domestic Islamic banking industry, bankers say.
Only one small Azeri bank, Kovsarbank, attempted to provide a full line of sharia-compliant services; the central bank of Azerbaijan revoked its licence in January 2010, saying banking laws had been violated, and the bank was closed.
By contrast, ex-Soviet Kazakhstan is bidding to become a centre for Islamic finance in the region. In July, the government-run Development Bank of Kazakhstan issued a $75 million sukuk, the region's first Islamic bond, and more sukuk from the country are in the works.
With only about 10 percent of Azeris praying regularly, according to polls, and women in mini-skirts strolling the downtown area of the capital Baku, Azerbaijan will not become a conservative Islamic state any time soon.
Even so, "Islamic finance is viewed not as a commercial activity, but as Islamic activism by most of the Central Asian and Azeri regimes, and therefore considered as part of the 'Islamic threat'," said Aliyev at the Central Asia-Caucasus Institute.
Azerbaijan's Islamist Party, banned in the mid-1990s on suspicion of spying for neighbouring Iran, operates underground; last year seven members were sentenced to long jail terms for setting up military units and preparing terrorist attacks.
The government, funded by rich reserves of oil and gas in the Caspian Sea, appears able to handle the security threat. But it also faces social pressure to permit more Islamic influence in daily life; last year hundreds of people protested to demand the right for girls to wear Muslim headscarves in schools.
Such tensions have hampered Azerbaijan's slow turn towards Islamic finance over the last couple of years.
Several banks have begun offering the option of making Islamic deposits which, instead of paying interest, provide returns from investments in sharia-compliant business ventures.
Azerbaijan's largest lender, International Bank of Azerbaijan (IBA), 50.2 percent owned by the finance ministry, is offering finance to small and medium-sized enterprises through an Islamic window, which allows it to segregate sharia-compliant assets from its conventional operations.
Last month IBA signed a "commodity murabaha" agreement to obtain $20 million of financing from the Islamic Corporation for the Development of the Private Sector (ICDPS), part of the IDB. It will use the money to offer Islamic trade financing to private sector companies in Azerbaijan.
The government is clearly interested in the Gulf's huge pool of investment funds. In July, IBA said it aimed to establish an Islamic banking subsidiary in Qatar by the end of 2012.
But with no legislative framework, Islamic finance is estimated at a small fraction of Azerbaijan's banking assets, which totalled 14.8 billion manats ($19 billion) in July.
Some commercial bankers say they expect such a framework eventually, but finance ministry press secretary Mayis Piriyev indicated it would not come soon.
"Current legislation of the Republic of Azerbaijan does not recognise Islamic finance, Islamic banking or their modes as legally acceptable practices and there are no proposals being discussed within the ministry," Piriyev said.
Central bank official Aygun Safarli also said there were no talks on a framework. "Current legislation does not allow us to bring these discussions up," she said.
That leaves companies such as Ansar Leasing, established in 2008 by the ICDPS, in limbo. Ansar is considering the issue of the country's first sukuk, which would pay no coupon and be issued at a discount from par value. The issue would be very small, perhaps $1 million with a three-year tenor, said Jeyhun Nagiyev, the company's director-general.
But in the absence of legislation, the issue would require a government decree to exempt it from taxes. Under current conditions, "it is impossible," he said.
(Additional reporting by Bernardo Vizcaino; Writing by Margarita Antidze; Editing by Andrew Torchia/Ruth Pitchford)