By Saeed Azhar and Umesh Desai

SINGAPORE/HONG KONG, June 22 (Reuters) - Malaysia, Asia's biggest Islamic finance market, can expect growing competition from Singapore and Hong Kong, which are raising their game to tap Middle East funds keen on investing in the region's economies.

Malaysia has a stranglehold on the global market for Islamic bonds -- two-thirds of such bonds, called sukuk, were issued in the Southeast Asian state last year -- and it has built up expertise in Islamic fund management and insurance.

But latecomers Singapore and Hong Kong, leading Asian centres for conventional private banking and fund management, are adapting their financial systems with a view to getting a slice of the $1.3 trillion in global Islamic finance assets.

Hong Kong, for example, is considering scrapping a stamp duty on Islamic finance structures to avoid double taxation. Singapore is soon to launch new guidelines for sukuk.

Both need to build up expertise in a complex area.

"Singapore and Hong Kong are established financial centres so their clearest path to a prominent position in Islamic finance is to encourage a critical mass of Islamic finance experts," said Hooman Sabeti, an Islamic law specialist at law firm Allen & Overy.

Singapore and Hong Kong are unlikely to supplant Malaysia as the leading centre in Asia, Sabeti said, because they lack a large, natural domestic market for Islamic products.

But they could become increasingly active in selling Islamic products to private banking clients and fund investors.

Indonesian, Bruneian and Malaysian investors who already own conventional financial assets in Singapore would be obvious targets.

A Merrill Lynch/Capgemini study last year showed that 19,000 individuals of Indonesian origin resident in Singapore held around $93 billion in financial assets.

Hong Kong, for its part, could provide a gateway for new investors interested in mainland China, constructing sharia-compliant products with underlying Chinese assets.

• TAX AMENDMENTS, INCENTIVES

Hong Kong and Singapore are not Islamic states and Muslims in each city are in the minority. But that does not preclude the emergence of an Islamic finance sector, as London is showing.

With their strong, corruption-free economies and robust banking and legal systems, Hong Kong and Singapore provide ripe environments in Asia for the development of products that comply with Islamic law, or sharia.

Singapore is offering incentives, while Hong Kong is amending laws to draw business and has propsed an Islamic bond issue by the city's airport authority.

"Hong Kong is now conducting a review of tax laws in Hong Kong to ensure that Islamic financial transactions will not be disadvantaged simply because of their special structure," said a spokeswoman for the Hong Kong Monetary Authority.

To get a level playing field, it needs among other things to eliminate double taxation on Islamic finance products structured to comply with Islam's ban on interest payments.

For example, in a mortgage under Islamic finance, a typical structure requires the financer to first buy the property and then sell it to the borrower on a cost-plus basis, so that the lender gets a profit rather than interest. Since that entails two sales, stamp duty is due twice over.

In February Singapore introduced a 5 percent concessionary tax rate on income derived from sharia-compliant fund management, lending and insurance.

It has succeeded in attracting Islamic banks such as Kuwait Finance House, which plans to manage regional funds sponsored by the group investing in Asia.

"There is huge potential for Singapore in the area of asset and fund management," it said in an emailed statement.
DBS Group Holdings , Singapore's biggest bank, last year set up Islamic Bank of Asia, the city's first Islamic bank.
Last month Japan's Daiwa Asset Management listed its first sharia-compliant exchange-traded fund on the Singapore Exchange.

In Hong Kong, Hang Seng Investment Management launched a sharia-compliant fund last year, and in March a $550 million exchangeable sukuk was listed on the Hong Kong Stock Exchange.

Rosita Lee, investment product head at Hang Seng Investment Management, said Hong Kong had the edge over Malaysia in pitching Islamic finance products to China-focused investors because there was a better understanding there of mainland policies.

But both Hong Kong and Singapore may need to adapt to satisfy investors who want separate regulation for Islamic banking.

Kuwait Finance House said it wanted Singapore to regulate sharia matters through a central body for Islamic banks and financial institutions. Such a set-up helped Malaysia create an environment where Islamic funds flowed into Islamic assets.

"Ultimately, if you want to sustain the industry as a key component of the financial markets, I would think that they require introducing some laws that are specific for the Islamic financial market," said Badlisyah Abdul Ghani, chief executive of Malaysia's CIMB Islamic Bank, a major sukuk deal maker.