“ISLAMIC finance” a few years ago was a vaguely understood term. Its appeal was limited to a small group of devout Muslims around the globe who wished to deal in finance on the basis of a strict interpretation of the Quran. Then two things happened.

The US launched the “war on terror” including strict controls on the movement of capital between the principal centres of global finance and the Muslim world. While the movement of funds to and from Muslim countries was being watched closely, oil prices increased sharply, bringing new windfall gains to many of these countries.

Oil producing windfall gains was not a new phenomenon for the oil producing and exporting countries in the Muslim world. It had happened before. Some three decades ago, large flows of funds to the Middle East and East Asia were either squandered on conspicuous consumption or placed in western financial banks.

Commercial banks in America and Europe were the main beneficiaries. They took in “petrodollars” as cheap deposits and on-lent them at heavy profits. The oil windfall created the banking windfall a few years later.

This time around, geopolitics combined with maturing economic attitudes in the Middle East created the right environment for the development of domestic financial markets. With this development has come the development of financial expertise in many places — in particular the United Arab Emirates.

The difficulties encountered by the Middle Eastern governments and entrepreneurs to operate in the West — in particular in the US — convinced them to keep their windfall incomes either at home or nearer home. This produced a bounce for Islamic finance. New financial instruments were developed.

In the early period, Islamic banking was the central element of Islamic finance. Now, new instruments were developed. A few years ago, Islamic banking was closely identified with institutions such as Al-Rajhi bank in Saudi Arabia.

That this became a highly profitable institution that benefited from a low cost of funding — most of its depositors were content to leave their money at the bank without asking for a return — and highly profitable opportunities for investment attracted new players not just from the Muslim world.

A number of western banks also entered the field. With new entrants entering the business, Islamic banking began to grow. Even with this growth, it is relatively small accounting for only one per cent of global banking assets.

While Islamic banking was growing, several Muslim countries began to develop other instruments. New Islamic products began to be developed that attempted to replicate what was happening in the non-Islamic markets.

One such instrument was the commodity ‘murabaha’, which emerged in the 1970s. A commodity ‘murabaha’ is a contract between a bank and its client for the sale of goods within a specified period of time at a price plus an agreed profit margin.

Profits are allowed under Islamic law — in fact, they are encouraged as a device for creating wealth in the Islamic community. The instrument is called a commodity instrument since the profits are made on the buying and selling of a commodity, usually non-perishable metals.

In the wholesale markets, Islamic finance can be divided into several categories of instruments. They include commodity ‘murabaha’; equities; property investment; ‘takaful’, or Islamic-compliant insurance; foreign exchange, including Sharia-compliant currency swaps; Islamic bonds, or ‘sukuk’; and structured products.

On the retail side of finance, Islamic instruments have been developed. Individuals can use current or savings accounts in banks which are based in theory on a profit-sharing principle.

In practice in many cases — this is certainly the case in Pakistan — this has represented simply a change in nomenclature with the use of the term “profit” replacing the term “interest.”

Personal loans based on the trading of a commodity similar to a commodity ‘murabaha’ and Islamic mortgages, which are in essence leasing arrangements, have also been created. Those participating in the stock market are allowed to buy shares only in those companies that don’t undertake forbidden activities such as gambling of production and consumption of alcohol.

Companies that have debt to equity ratio of more than 33 per cent are not acceptable for Islamic finance. Stocks of insurance companies are also not allowed to be traded by those who wish to abide by Islamic principles. Insurance involves a degree of uncertainty, risk or speculation, known as ‘gharar’, which, like gambling, is prohibited.

In the past couple of years, ‘sukuk’, a bond that provides returns on the basis of profit rather than as a fixed interest has attracted the greatest amount of attention. The current size of the market is estimated at about $70 billion. Even the government of Pakistan has tapped this growing market.

Given the amount of liquidity available in the markets in the Middle East, a number of non-Islamic enterprises have entered the ‘sukuk’ business. A couple of oil exporting companies from the United States have raised capital this way, thus passing on the risk to the holders of ‘sukuks’.

In fact, raising capital through a ‘sukuk’ type of instrument captures the essence of Islamic finance. It does not guarantee fixed returns but pays on the basis of whatever profits exploration activities yield.

More recently, structured products have entered the domain of Islamic finance. But there are some unresolved questions about some of the features of these types of instruments.

For instance, can instruments be offered in Islamic markets that offer protection against company defaulting when any type of speculation is banned under Islamic law? Opinions differ among scholars in this area.

More conservative interpreters of Islamic law believe that practices should not be stretched to accommodate instruments that are inherently repugnant when viewed in the context of the Quran and Sharia. These doubts notwithstanding, innovation in the field continues. Experimental ideas are now being developed in product and infrastructure finance. The field that is attracting most interest is derivatives and structured finance.

The need for innovation is growing as new products are developed. It is felt that the risk associated with some of them need to be dealt with by creating derivatives.

Derivatives are a device that spreads risks across a broad range of investors, reducing the impact if something goes wrong. But this raises an obvious question: can derivatives be defended in light of the Quran’s ban on ‘gharar’, speculation?

Given the uncertainties that surround some of the developments in Islamic finance has put focus on the work of a small number of scholars who advise governments, institutions and individuals on issues concerning “compliance to Sharia.”

This has brought prominence and profit to a small group of experts that claims authority on the subject of compliance — what makes a particular financial product or a particular approach in finance complaint with the Sharia. Leaving the answer to a band of scholars has had the result of creating a great deal of confusion in the sector.

As McKinsey, a western consultancy firm says in a recent report: “The lack of standards inhibits the development of the international Islamic banking markets and results in an industry that is little more than a collection of national strongholds.”A recent report by KMPG, another consulting group that is getting involved in Islamic finance issues, also raised some concerns with the way the industry was developing. “To begin with, there is no common approach on regulatory frameworks, and there is varying interpretation of Sharia compliant products,” says the report. “The resulting lack of transparency in operations, and the varying degrees of governance, raises questions about how effectively Islamic financial organisations are managing their internal controls.”

To address these problems, some governments in Muslim countries are making attempts at coherence. Bahrain created the Accounting and Auditing Organisation for Islamic Financial Institutions 17 years ago. The AAOIFI now works on two levels. It runs a Sharia board of 17 religious scholars who are charged with the task of unifying the various opinions issued on various subjects included in the broad subject of Islamic finance.

“The industry has to be standardised — otherwise it will be local,” says Muhammad Nedal Alchaar, the head of AAOIFI. For Islamic finance “to be a real viable alternative system it needs harmony. You cannot have a product be one thing in Bahrain and another in Malaysia.”

Standardisation of regulation in Islamic finance is a move that needs to be made if the business is to mature and become credible. Treating the question of “Sharia compliance” on an ad hoc basis makes the issuance of various products a very expensive business. It also increases the hold a small number of experts have on this activity.

There is no reason why global compliance standards cannot be developed let alone national standards as being worked upon by Bahrain and Malaysia. It is only by moving in that direction that Islamic finance will mature into a seasoned activity.

The second level on which AAOIFI is operating is expanding the expertise available in the area of Islamic finance. It has started giving crash courses and issuing professional certifications for accountants working in the business. This way it hopes to loosen the grip that a small group of people now have on this industry.

There is little doubt that the scope, depth and reach of Islamic finance will grow with time. There are several estimates of its current size. The Financial Times published a survey of the subject a few weeks ago and quoted some estimates. According to Oliver Wyman, a consultancy operating in the area, there are $300 billion of assets managed according to Islamic principles. There are 280 institutions involved in the business with London becoming a centre for new developments.

But there are other calculations that put the size of the industry at a much higher level. The Financial Services Authority in the UK, for example, recently calculated the size of the business at $500 billion.

Should Islamic finance develop into a business that is separate from general finance? This is the intention of those who wish to give it a distinct flavour, arguing that several Quranic injunctions cannot be incorporated in general finance.

There are also those — and these are notable Muslim scholars — who argue that it is a mistake to move along a line that is so separate from the general trend. This is a subject for perhaps another article. In the meantime, it should be noted that while there is expansion and much innovation in Islamic finance, and while some of the initial push was given by Pakistan during the time of President Ziaul Haq, the country has lagged behind as an innovator in this field.

It has become a follower rather than a leader. Innovation requires an environment that is stable; this Pakistan has not had for several decades.

IN the last few days, the United States has threatened Pakistan with military action in parts of the tribal areas. The US National Intelligence Estimate report says that the Al Qaeda is regrouping. This makes the US feel threatened and, and as usual, the giant is lashing out, vowing vengeance. This is not entirely unprecedented. In 2006, President Bush made a similar statement. However, the timing is a little odd in the present context.

In the immediate aftermath of the Lal Masjid episode, with bomb blasts taking place and civil war staring us in the face — is this the time to threaten one’s ally with war? And now that it has happened, what will be the fallout of such a threat? These are the questions which need to be discussed.

First, is the United States correct? Are the Taliban and the Al Qaeda really regrouping in Pakistan? There is some evidence that, whether they are Al Qaeda or not, militant religious groups are gaining strength in parts of Pakistan.

There are radio stations issuing threats of closing down girls’ schools, destroying video shops and putting barbers out of business in Swat (where Maulvi Fazlullah is a force to be reckoned with) and parts of the NWFP and Balochistan.

There are many people who point to the presence of camps of militants in Pakistan. In short, it does appear that Islamic militants are not on the run as the US apparently expected them to be. Indeed, some of them feel strong enough to impose their rule over parts of Pakistan’s territory.

Now the question is whether the state can control them but does not, or whether it simply cannot control them any longer. This is not an easy question to answer for the likes of me who have no secret information. Published sources are not very helpful either.

It is obvious that, for a long time, the military and intelligence establishment of Pakistan nurtured militants. They used them first in Afghanistan with the help of the Americans. Then they used them in Kashmir. In Afghanistan, they were enamoured of the idea of ‘strategic depth’, and this meant strengthening the hands of the most ruthless of the warlords to keep the Pashtuns dominant.

In Kashmir, of course, they aimed at getting the Indians to bleed so much that they would come to the negotiating table. Both objectives bled Pakistan and both failed. This is known.

What is not fully clear is whether the same policy, this time in favour of the Taliban, is still in place at some level? If it is, and some people who know the area swear it is, it is so disastrous that it makes one shudder. If it is not, is it possible that there are free or rogue elements that are sold on discredited and abandoned policies and operate on their own? If so, the state’s job is to ensure that such rogue elements are thrown out of business.

The Pakistan establishment, like Frankenstein, has created a monster that is threatening its creator. Even if some elements in it are still protected by the state, it is clear that others are at war with it.

Movements have a dynamism of their own and it is unrealistic to assume that everyone will follow the script written by someone else (even if it is the ISI) to the letter. That does not happen, which is why conspiracy theories are often misleading.

So, while it is possible that the militants were patronised by the establishment at some time, it is not possible that everything they do — which includes attacks on the army, the paramilitary forces and the police — is also controlled by the establishment. We are in a civil war-like situation and the problem is that our common people are sitting on the fence.

The government’s mistakes can make our people join the militants — at least in feelings — or moderate, pro-democracy citizens. The end of the Lal Masjid episode, with Maulana Ghazi turned into a martyr and a large number of young people missing, turned the tide against the moderate forces. Those who were cheering the government a day earlier now took to reviling it.

Similarly, on Friday, when the people found human organs and items belonging to the students in the debris of the Lal Masjid, they found emotional symbols. The very controversy over the colour of the mosque — it was given a yellowish tone but the Islamists wanted it red again — found resonance among anti-government groups.

However, there are few takers for the politics of explosions which are being attributed to the militants. So, in terms of the follies committed, the match between the Islamists and the moderates seems to be heading to a draw. But the series has only begun.

There are many dangers to liberal democracy in Pakistan. The lawyers movement and the restoration of the Chief Justice gives us hope that positive forces can be revived but they cannot become strong or thrive unless certain conditions are met. One of these conditions is that there should be democratic leaders who will get votes.

Benazir promised to be such a leader but she is jeopardising her potential by appearing to go soft on Musharraf’s right to rule Pakistan while remaining head of the army. If Benazir really joins Musharraf, the moderate forces will lose a leader whose name has leftover charisma even now. Then, in terms of political parties, there will be such a division of forces that the liberals will lose out.This scenario will not create new Islamists but it will create more space for the ones who already exist to empower themselves. And this time I doubt if this will create the kind of vacuum which helped General Musharraf stay in power in 2002. This time it will be a disaster for liberal democracy.

The major danger — and the one I began with — is the possibility of American intervention. If the Americans bomb the place and fly off to safety they will leave the country awash in anti-American sentiment. Even the liberal democrats will join the religious militants on the one-point agenda of anti-Americanism.

If, however, they actually send troops to wipe out Al Qaeda hideouts they will have a war on their hands. Moreover, no government of Pakistan will be able to stand the fury of the people if the army does not fight the Americans. And if it does, we will have the greatest disaster of the century the likes of which we have never seen.

Both scenarios will empower the Islamic militants because the language and the emotive symbols used will have a religious appeal. This kind of diction will supply the emotional needs of the people in this time of crisis, and moderate forces will have to keep quiet and leave the field to the hardliners.

Just as the Al Qaeda got a foothold in Iraq because of American intervention, the Islamic militants will become major powerbrokers in Pakistan if America is stupid enough to intervene.

No matter what is happening in Pakistan, no matter what the omission or commissions of the establishment forces in Pakistan might be, it will not help the Americans to intervene militarily in Pakistan or even threaten to do so. If anything can help the US — and Pakistan — it is to let Pakistan fight its own battle, strictly in the interest of its own people, in its own way.

American help is welcome in order to feed and clothe the people so that they do not join militant forces out of hunger or anger. American help is needed to educate our young people here and in America. But it is not needed to make the elite richer than it already is and, above all, it is not needed to crush our people through American soldiers and direct or indirect attacks. If the US really wants to help itself — and Pakistan too — it should stop threatening Pakistan with attacks.

IT goes without saying that Asia matters to the European Union. Europe has a major stake in a stable and prosperous Asia.

Our political, security and economic interests are more intertwined than ever. But our relationship goes far beyond the economic and trade realm: the European Union and its Asian partners contribute actively together to resolving different regional and global problems.

We also share an important vision in which a system of global governance, with regional structures as its cornerstones, effectively addresses transnational problems.

It is with this vision that I am once again returning to Asia in early August for the ministerial meeting of the Asean Regional Forum (ARF) and bilateral consultations with our Asean partners.

The progress we have made together over the past year is impressive, perhaps even the most important in our 30 years of formal ties. And, the EU’s early accession to the Asean Treaty of Amity and Cooperation can only bring us closer still, with positive implications for the political and security interests of both groups of countries.

We have also agreed to strengthen our political exchanges further and to promote practical cooperation in many areas of mutual interest.

One such area, where we work very well together and are set to become closer still, is crisis management.

We are, for example, open to sharing more information, boosting technical cooperation and strengthening capacity-building in this field. It was crucial for the EU-led Aceh Monitoring Mission (AMM), which supervised the peace agreement between Indonesia and Aceh rebels from the summer of 2005 to the end of 2006, that Asean partners participated in it. This not only helped ensure the success of the mission but also led to the creation of real ties between the two regional organisations.

As a result of our joint efforts and, of course, the achievements of the Indonesian government, Aceh was stabilised and is now is developing steadily after 30 years of conflict and the devastation wrought by the 2004 tsunami. Its development, which included the elections held last year, was so positive that the Aceh Monitoring Mission was able to complete its work and leave the province.

But the European Union has not left Aceh. On the contrary, we are continuing to give active support to the reconstruction efforts of the Indonesian authorities and the local administration in Aceh with a very substantial and visible development programme.Just six weeks ago, the EU deployed another mission on Asian soil, a police training mission in Afghanistan, which is also open to Asian partner countries. This mission seeks to help establish sustainable and effective civilian policing arrangements under Afghan ownership and in accordance with international standards. The fact that the mission is to run for at least three years underlines the EU’s increased and long-term commitment to security and stability in Asia.

We could also envisage cooperating more closely with our Asian partners in future crisis management operations on other continents.

We are following with great interest the historic decisions by Asean to further develop the South East Asian community and its work on the Asean Charter, which includes the development of an appropriate institutional framework.

For obvious reasons, the EU appreciates the ambitious integration project of another region. It has also lent practical support. I myself have met both the Eminent Persons Group and the High-Level Taskforce of Charter drafters and I was very impressed by their vision and commitment and the pertinent questions they asked about the EU’s integration process.

In our European experience, far-reaching political and economic integration has not only overcome divisions between former enemies and ensured stability and prosperity in Europe but it has also proved to be the best solution in tackling regional and global problems that do not stop at national borders.

The ARF, which we value greatly as the only political and security dialogue forum in the Asia-Pacific region, is increasingly recognising the need to find collective solutions to trans-boundary security issues, in particular when it comes to new challenges. Once a year, the ARF meets in a unique forum that brings together the foreign ministers of Asian and Pacific countries and their key partners for dialogue on a wide range of issues with a bearing on Asian security.

In addition to this fruitful exchange, the forum is also achieving concrete outcomes at the various seminars and workshops which have made it more results-oriented than in the past. The European Union, which attends and contributes to the ARF as a long-standing dialogue partner of the region, is looking forward to the creation of a mechanism that enables the ARF to be active between meetings. This will be a very important and welcome step towards the construction of a regional architecture for Asia.

Asia matters to Europe, and it also goes without saying that the European Union matters to Asia. Together, the EU and Asean represent two regions, 37 countries and over one billion people. In Europe, Asia has a partner in its search for solutions to global problems such as climate change, energy security or organised crime. It has a partner in the economic and trade realm and it has a partner in development issues. Only together can we meet the challenges of the future.

The writer is EU high representative for common foreign and security policy.