Indonesia is counting on people like Nur Hanifah, a 50-year-old widow who sells plastic buckets and inflatable kiddie pools, to help it catch Malaysia, a country one-tenth the size that leads the world in Islamic finance.

Hanifah took out a Shariah-compliant loan from PT Bank Muamalat Indonesia after her husband’s death to help finance a store on the ground floor of a shop in Serang, two hours’ drive west of Jakarta. While she doesn’t pay any interest, borrowers like Hanifah typically must give the bank 40 per cent of their profit plus part of the principal each month.

“When times are good, I pay more on my loan than most people,” said Hanifah, whose monthly take is about 50 million rupiah ($5,189). “But I won’t have to worry when times are bad. I don’t have to pay anything when I’m not turning a profit.”

Loans like Hanifah’s could help Indonesia, the country with the world’s largest Muslim population, narrow the gap with its neighbour. It’s speeding up government approvals and fixing a fragmented regulatory system as part of an effort to reach more un-banked Muslims and increase the portion of Islamic assets in the banking system to 15 per cent by 2017, from 4.3 per cent.

That’s creating opportunities for global banks including Standard Chartered Plc and HSBC Holdings Plc, both based in London, which are issuing financial products that comply with Islamic law, or Shariah, as fast as regulators allow. It’s also attracting interest from Malaysian lenders across the narrow strait separating the two countries.

“Indonesia is only now undergoing wider financial reforms, of which Islamic finance is a part, to tap international capital markets especially from Gulf investors,” Abas A. Jalil, chief executive officer at Amanah Capital Group Ltd., a Kuala Lumpur- based consulting company, said in a December 6 interview. “Bank Indonesia could only recently begin organising laws for the non-Islamic side, let alone the Islamic, as they were hindered by the government and then the Asian financial crisis.”

Sukuk : Southeast Asia’s largest economy sold $1 billion of global Islamic bonds in November, with bids exceeding supply by five times. Buyers in the Middle East accounted for 30 per cent of the order book, compared with 23 per cent in Asia, 20 per cent in Indonesia, 12 per cent in the US and 15 per cent in Europe, according to Loto Srianita Ginting, director of government securities at the finance ministry’s debt-management office.

The government has issued Shariah-compliant sovereign bonds, known as sukuk, at mostly regular, two-week intervals, setting a record of 57.1 trillion rupiah last year compared with 34 trillion rupiah in 2011.

It may offer about 53 trillion rupiah this year, Dahlan Siamat, Islamic financing director at the debt-management office, said by text message.

Indonesia ranks fifth in the amount of outstanding Islamic bonds, after Malaysia, Saudi Arabia, United Arab Emirates and Qatar, accounting for 4.4 per cent of the world’s total, according to a Malaysian central bank report. Malaysia represents 62 per cent of the global sukuk outstanding. As of the end of the first half of 2012, it had $129.4 billion outstanding compared with $9.3 billion for Indonesia.

Interest ban: Indonesia allows 16 Islamic-banking products, compared with 59 in Malaysia, according to the countries’ central banks. Regulators in Indonesia are assessing a 17th, a Shariah-compliant instrument for banks to hedge against currency swings, said Edy Setiadi, executive director of Islamic banking at Bank Indonesia.

The global Islamic finance industry is expanding at an average annual rate of 15 per cent, according to Malaysia’s Securities Commission. That’s almost three times as fast as the 5.5 per cent increase for all financial assets in 2010 cited in a 2011 McKinsey Global Institute report. It will more than double to $2.8 trillion in 2015, from $1.1 trillion in 2011, the Islamic Financial Services Board in Kuala Lumpur estimates.

One reason for the lag was that the country was hit harder during the Asian financial crisis that began in 1997. Indonesia spent about 57 per cent of the value of its gross domestic product to restructure its banks from 1997 to 2001, according to an IMF report. That compares with the 16 per cent of GDP that Malaysia spent to revive its financial system from 1997 through 1999.

Investment limit: Bank Indonesia didn’t announce rules regulating foreign ownership of local lenders until July, setting a limit of 40 per cent for both Islamic and non-Islamic lenders.

Malaysia’s central bank, Bank Negara Malaysia, which has been independent since its establishment in 1959, revised its law seven years ago to allow foreigners to hold a larger portion of Shariah-compliant banks than of conventional lenders to spur Islamic banking. The authority increased the limit to 49 per cent in 2005 from 30 per cent, and to 70 percent in 2009.

HSBC, the world’s largest underwriter of sukuk for both government and corporate issuances, had a 24 per cent global market share totaling $11.1 billion in 2012, according to data compiled by Bloomberg. Three per cent of that was in Indonesia. Cheaper borrowing costs spurred Islamic bond offerings to an all-time high of $46.3 billion last year, exceeding the previous record of $36.7 billion for 2011, the data show.

Indonesian companies will probably break corporate sukuk records this year after issuing less than one per cent of Malaysia’s 95 billion ringgit ($31.5 billion) in 2012, according to estimates by PT Danareksa Sekuritas and PT Indo Premier Securities, Indonesia’s top two arrangers.

Islamic lenders in Indonesia including Bank Muamalat, the PT BNI Syariah unit of PT Bank Negara Indonesia and CIMB Islamic, part of Malaysia’s second-largest banking group, have said they want to provide fixed-rate deposits to consumers so they can compete directly with non-Islamic banks. Such accounts have been available in Malaysia since 2007.

Shariah-compliant banks can offer fixed rates on deposits using a contract to sell and repurchase assets with a markup and deferred payments, called murabaha. A bank may offer to sell and repurchase a property with 10 per cent markup paid over two years, resulting in stable payments of five per cent each year.

The number of Indonesians using Islamic financial products increased 37 per cent over the past year through November 30 compared with a 32 per cent rise in the previous period and 19 per cent the year before, central bank show. That’s still only 13.8 million people in a country of 208 million Muslims.

Hanifah, the shop owner, is one of them. She said she despaired of making monthly interest payments on a regular bank loan after her husband’s death in an accident in 2004. It took her five years with the help of relatives to repay a debt of 32 million rupiah at a rate of 18 per cent without any income.

This time it’s different. “When I didn’t turn a profit one month, the bank didn’t send thugs to demand payment,” she said of the Bank Muamalat loan for her shop. “It sent my account manager instead to help me rearrange the furniture and showcase the products better, because my profit is theirs, too.”

Hanifah, who wears a headscarf, declined to say how much she borrowed or what she clears each month.

Sharing risk : The type of loan she took out from Bank Muamalat, whose Shariah-compliant lending rose 93 per cent in the first nine months of last year, gets around the ban on interest by sharing both the borrower’s earnings and the lender’s risks. If there’s nothing left after expenses, borrowers owe nothing that month.

Lenders pay an agreed proportion of their profits as returns on customer deposits, causing rates to fluctuate depending on a bank’s profit. When the bank is more profitable, clients earn bigger returns on their savings.

Shariah-compliant banks can guard against currency swings by signing two sell-and-repurchase agreements, similar to the method used for fixed-rate deposits, in different currencies using agreed-upon exchange rates.

Indonesia will require non-Islamic banks operating Islamic- banking windows in their branches to set up independent units by 2015 to prompt them to inject more capital into the business, according to Setiadi of the central bank.

Nations including Pakistan, South Africa and Kazakhstan are seeking to develop Islamic finance by revising rules and offering incentives. Malaysia and Ireland have treaties to remove double taxation on the transfer of assets used in Islamic bonds and transactions.

—Washington Post/Bloomberg