Kuwait Finance House's Malaysian unit is now a year old and putting the final touches on an Islamic bond issue for a Chinese state-owned company -- a world first.

The bank says details haven't been nailed down, but analysts expect the bond will be issued through a special-purpose vehicle registered in Labuan, Malaysia's offshore banking hub. The bond, to be structured on Islamic principles -- which, for example, forbid charging interest -- will allow the Chinese power company to tap a major new source of funds: investors from the oil-rich Persian Gulf who want to buy into Asia's emerging markets.

Predominately Muslim Malaysia has built the biggest Islamic bond market in the world, and the country is using that expertise to become a dominant global Islamic banking center. Malaysian banks are starting to expand to the Gulf, and Gulf investors and banks are using Malaysia as a springboard into the Asian region.

"Malaysia has done a lot of work. They've come out with regulations for an Islamic money market and capital market, they've set up all the right infrastructure," says Salman Younis, managing director of Kuwait Finance House Malaysia.

In 2001, Malaysia, which has had a small Islamic banking sector since the late 1980s, decided to carve an international niche for itself and put in place a set of laws and incentives compliant with Islamic law, or Shariah, to foster the industry. Islamic retail banking has begun to blossom, and now accounts for 12% of total assets and 12% of financing, mostly for cars and homes, in the Southeast Asian country of 25 million people. But it is Malaysia's Islamic
debt market that has really boomed.

About $30 billion of the $41 billion in Islamic bonds issued globally since
1996 have been arranged and issued in Malaysia, according to credit-ratings agency Moody's Investors Service. Malaysian investment bank CIMB Banking Group has become the world's biggest Islamic bond issuer.

In the process, banks like CIMB have dreamed up new financial products that the Muslim world has never seen before, such as unsecured Islamic bonds and asset-backed securities linked to a company's trade receivables. Malaysia-based units of international banks such as HSBC Holdings PLC and Citigroup Inc.'s Citibank have jumped into the game, too.

The Islamic banking market is one worth fighting for: There are about $250 billion in assets in Islamic banks world-wide, and that total is growing 15% a year, Moody's estimates. There is an additional $300 billion under management in Islamic mutual funds. That is stoking an appetite for Shariah-compliant debt as bankers seek to offset liabilities, increasingly sophisticated Muslim investors seek to diversify their portfolios and companies look for new sources of
funds.

Even Asian companies with no link to the religion -- such as the Chinese
power company with which Kuwait Finance House is working -- are issuing Islamic bonds.

"Issuers in this part of the world see Islamic finance as a way to tap
another source of funds," Kuwait Finance House's Mr. Younis says. "The Gulf markets are very liquid, and investors there are very interested in diversifying into
Asia."

Banking analysts credit the Malaysian government's sustained efforts to foster the Islamic bond industry.

It set up standardized guidelines for Islamic bonds, or sukuk, in 2004, runs a centralized Web site that lists all the Islamic bond issuances in a
transparent way and gives tax deductions on expenses linked to issuing a bond.

So far, the Malaysian market has been comprised mainly of local
corporate-bond issuers. But that is changing.

Last month, CIMB announced that it will jointly lead a $200 million bond for United Arab Emirates-based National Central Cooling Co., or Tabreed, the largest air-conditioning company in the Middle East.

The deal marks the first time a Malaysian bank has acted as lead manager on a rated Islamic bond for a Middle Eastern corporation.

Malaysia is taking other steps to globalize its entire Islamic banking
system: Malaysia awarded three Gulf-based Islamic banks local licenses two years ago, and in June, CIMB set up a joint-venture in Bahrain to better access the Gulf.

Malaysia faces some hurdles in its transition from domestic Islamic-banking heavyweight to global player. For one thing, its bankers have a tough time convincing conservative Muslims from the Middle East that some of their innovative new debt products fully comply with Shariah. While Islamic scholars agree on the basics -- Islamic law forbids anyone from profiting by trading debt and forbids generating money from money -- they argue over whether some new products pass religious muster.

For example, Muslim financial experts concur that lawful Islamic bonds are linked to a pool of underlying, tangible assets, like a piece of property or a toll road, and that returns to investors are generated from recurring profits or sales of those assets -- not from an interest rate.

But tastes differ once you get beyond the plain product: Malaysia was the first Muslim country to permit issuance of unsecured Islamic bonds, reasoning that as long as a company has enough tangible assets to back the bond at the time it is issued, it complies with Islamic law, even if those assets, such as land, might not be on the company's books later in the bond's tenure.

Gulf countries, on the other hand, argue that such a bond needs to be backed by a specific, tangible asset throughout its entire tenure.

As a result, Malaysian bankers may need to tone down some of their innovative ideas to secure a foothold in the Middle East market.