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Jul 18, 2016 | 09:45 GMT

Russia's Muslim Regions Turn to the Gulf for Help

Russia's Muslim Regions Turn to the Gulf for Help
(KIRILL KUDRYAVTSEV/AFP/Getty Images)
Forecast Highlights

  • As Russia's financial circumstances worsen, many of the country's Muslim republics will try to attract outside investment by implementing Islamic finance tools and establishing joint banks with Muslim countries, despite federal regulations.
  • Fearing the potential political and social consequences, the Kremlin will try to keep the regions' Islamic financing and Persian Gulf ties to a minimum unless they funnel through Moscow.
  • The prospect of the Muslim republics growing distant from the Russian government or being influenced by foreign states will continue to trouble Moscow, particularly since many of those regions pose the greatest internal threats to Russian security.

As Russia's economy continues to stagnate, the country's 83 regions are being forced to compete with one another for outside investment to stay afloat. The quest for funding was a popular theme at the recent St. Petersburg International Economic Forum, where regional governments and corporations tried to woo foreign partners and financiers. Some regions have focused their campaigns on Asia and Europe: The Kaluga and Kaliningrad provinces, for example, have signed investment deals with Bavaria, and Kaluga's governor visited Vietnam earlier in the year seeking funding. But four of Russia's Muslim republics — Tatarstan, Bashkortostan, Chechnya and Dagestan — have set their sights on Muslim states in the Middle East and Southeast Asia, a strategy that has put Moscow on edge.

Making Ends Meet

Russia's Muslim population is growing rapidly, thanks to high fertility rates and an influx of immigrants from predominantly Muslim Central Asia. Now nearly 13 percent of Russians are Muslim, and most live in the country's eight autonomous Muslim republics: Tatarstan, Bashkortostan, Chechnya, Karachay-Cherkessia, Kabardino-Balkaria, Ingushetia, Dagestan and Adygea. Under Russian law, these regions — autonomous republics because of their non-Russian majorities — can choose their own languages, constitutions, presidents and security structures. Moscow granted the regions these freedoms, albeit begrudgingly, in the wake of the North Caucasus wars in an effort to quell secessionist sentiment and instability.

The Muslim republics' economies vastly differ from one another. Tatarstan and Bashkortostan, for instance, are two of the most developed regions in Russia because of their oil and agricultural wealth. Both regional governments control their own energy firms, which provide the bulk of the regions' budgets, as well as their own banking systems. In fact, according to Forbes, Tatarstan's two largest banks rank among Russia's most reliable banking institutions. Chechnya and Dagestan, meanwhile, are still struggling to overcome the damage caused by nearly two decades of war with Russia, as are their neighbors in the North Caucasus. Economic growth in these republics relies on federal subsidies, which have been substantial in recent years. Over the past decade, Kremlin funds have made up 80 to 90 percent of the Chechen and Dagestani budgets and more than half of the other North Caucasus regions' budgets. Similarly, the banking systems of Chechnya and Dagestan are dependent on Russia's federal banking system, a stark contrast to the independent banks of Tatarstan and Bashkortostan.

Despite their economic differences, Russia's Muslim republics have been uniformly hurt by the collapse in global oil prices. Growth has slowed in Tatarstan and Bashkortostan, while the North Caucasus regions have seen their subsidies halved amid the Russian recession. For the past two years, Chechen President Ramzan Kadyrov has even had to dip into his administration's private reserves to make up for his region's budgetary shortfalls (though, admittedly, the reserves were built with funds gained by docking civil servants' salaries). Moscow has not stepped in to address the issue, leaving Russia's regions to look for external investment and financial support on their own.

Finding Financiers in the Muslim World

Some of Russia's Muslim republics have more experience in finding outside backers than others. Tatarstan and Bashkortostan have been fairly successful in maintaining the interest of foreign investors for the past 10 years; Tatarstan is considered Russia's best region for investment, while Bashkortostan is among the top 10. Each has industrial and high-tech economic zones and enough independence from Moscow to strike deals with foreign partners. By contrast, the republics of the North Caucasus have attracted very little foreign investment over the years.

Across the board, though, Russia's Muslim republics are weighing the merits of adopting Islamic lending laws to solve their financial predicament. Unlike conventional finance rules, these laws prohibit lenders from charging interest. Instead, loans more closely resemble investments in specific projects, deriving profit from those projects' success. Islamic financing mechanisms are also often backed by physical assets, making them less risky than their conventional counterparts. From the republics' perspective, the use of Islamic financing would draw the interest not only of Muslim consumers at home but also of other Muslim states.

But their plan has hit a snag: Islamic financing has been legally banned in Russia because it does not require interest payments as traditional financial instruments do. Some Islamic finance tools that resemble profit-sharing agreements between lender and borrower have also been prohibited because they are technically classified as "commercial activities," which Russian banks cannot participate in. Some banks, including federal ones, have found loopholes to skirt the law. Others, such as those in the Muslim republics, have simply ignored it outright, issuing transactions under Islamic banking guidelines or negotiating with foreign financial groups to start implementing them.

The Kremlin, meanwhile, has neither fully supported nor blocked the regions' use of Islamic financing. In March, the Central Bank of Russia approved a roadmap for Tatarstan to begin exploring Islamic banking mechanisms as a test case. The government has yet to change Russian laws on the matter, however, and according to Tatar banks, Russian banks have stalled talks on joint projects with Tatar banks and foreign lenders over the past year. So Tatarstan has struck out on its own. Last year, the region's largest bank, AK Bark, began to issue Islamic bonds that come with far lower rates and fees than its eurobonds do. At the same time, Tatar insurance operator Alliance began to sell an Islamic financial product called Halal Invest.

Tatarstan is hoping that its use of Islamic finance will pull in investment from members of the Gulf Cooperation Council (GCC), with which the region has had close ties for some time. In the past few years, funding from the Gulf states has indeed risen dramatically, jumping from $60 million in 2011 to $760 million in 2015. Most of the new money has been funneled toward the Smart City being built in Tatarstan's capital, Kazan. The special economic zone will host biomedical, hospital and academic research centers, along with information technology development labs, employing some 50,000 people in total. By venturing into Islamic financing, Tatarstan is attempting to secure even more resources for its cornerstone project. To that end, it has entered into talks with Saudi Arabia's Islamic Development Bank, which has promised to make Tatarstan the Islamic finance hub of Russia within the next few years.

Chechnya has not been far behind. Like Tatarstan, Chechnya has sought partnerships with the Gulf states — including Saudi Arabia and the United Arab Emirates — over the past few years. Kadyrov has discussed several construction projects in Grozny with Saudi and Emirati officials, though both delegations expressed concern over the region's lack of Islamic money-transfer systems. In response, the Chechen president announced early in 2016 that his region would open an Islamic bank and consult with an Emirati investment firm to establish a joint venture with a GCC partner. A high-ranking Saudi delegation is scheduled to visit Chechnya in the coming months to revisit investment talks.

Bashkortostan and Dagestan have been slower to follow in Tatarstan and Chechnya's footsteps. Bashkortostan has close ties to Tatarstan and has opted to wait and see whether its efforts to create a viable Islamic financing system pan out. Similarly, Dagestan has put off creating its own system until it sees how nearby Chechnya's fares.

Russia Moves to Minimize the Gulf's Clout

The question now is whether Russia will allow Gulf state financing to continue. For years, Moscow avoided making deals with the Gulf states because of its complicated relationships in the region. But when its ties to the West began deteriorating in 2014, Russia began to look for other partners. After sapping up its major investment avenues in China, the Kremlin finally began to reach out to the GCC. Between 2014 and 2015, the Gulf states pledged some $25 billion in funding for Russia — but Moscow kept those funds tightly controlled through the Russian Direct Investment Fund.

Now that the Gulf states are reaching deeper into Russia by bypassing Moscow and negotiating directly with the regions, the Kremlin is faced with a dilemma. On one hand, it cannot afford to prop up the Muslim republics on its own. On the other, it also cannot allow the regions to fall into disrepair for fear of the instability it may cause, and it is unwilling to alienate its rapidly expanding Muslim population. But from Moscow's perspective, the rise of Islamic financing is worrisome for a couple of reasons. For one, the Sharia principles inherent in Islamic financing do not mesh with those of Russia's banking system. Moreover, the GCC is interested in promoting Sharia principles more broadly within the republics' communities — something that runs counter to Russia's history of clamping down on strong, independent Islamic ideologies among its people. The Kremlin will accept the Gulf states' money — if it chooses to do so — only as long as it can ensure that the funds go to projects that will not undermine its hold on the Muslim republics.

In addition, Moscow is concerned that the diversification of the republics' investment and business options could further distance them from the federal banking system, or by the same token, grant them greater independence. Nearly all of Russia's Muslim republics have experienced bouts of secessionism, though some have been stronger than others. The Kremlin, therefore, will be careful not to give the regions too much room to establish robust and independent financial systems. Indeed, Tatarstan's two biggest banks have already complained that Russia's federal banks, VTB and Sberbank, are aggressively trying to expand in the region, pressuring Tatar banks to give up some of their business in the process.

The Kremlin is also wary of GCC states gaining direct avenues of influence in Russia's Muslim republics. Concerns about color revolutions and infiltration by other states have led the Kremlin to enact a series of draconian laws that label any foreign money entering Russia a "foreign agent." Moscow has also begun monitoring all Russian entities that do business with foreign corporations. Because the Kremlin does not consider the Gulf states allies, it will likely scrutinize partnerships involving their firms even more closely. That said, not all GCC companies have political agendas. Though Mazcorp, for example, maintains deep ties with Abu Dhabi's royal family, the Saudi-based Islamic Development Bank comprises 56 member states and cannot easily be used by Riyadh to advance its goals abroad.

Russia is especially distrustful of ties forged between the GCC and certain Muslim republics, such as Chechnya. For more than two decades, Moscow has firmly maintained that the GCC states (alongside the United States) instigated the First and Second Chechen Wars. The Kremlin claims that Saudi Arabia, in particular, implanted its Wahhabist doctrine in the region and provided arms, supplies, training and support — largely through various charities and humanitarian organizations — to Chechen militants. June negotiations between Kadyrov and Saudi Deputy Crown Prince Mohammed bin Salman's aide have undoubtedly rekindled Moscow's fears. During the talks, the two discussed Saudi Arabia and other Arab states participating in joint training at Chechnya's International Special Forces Training Center.

Moscow will likely continue to put national security and Russian unity ahead of the needs of its growing Muslim population, no matter how dire the regions' financial situations become. Though the Kremlin cannot force its Muslim republics to ignore the opportunities presented by Islamic financing and investment, it will do what it can to insert itself in the process to rein in their budding relationships with the rest of the Muslim world.

Lead Analyst: Lauren Goodrich

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