The Reserve Bank of India (RBI) has proposed working with the government to introduce interest-free banking to tackle financial exclusion for religious reasons, potentially opening Islamic finance to the largest Muslim minority population in the world.
India's central bank made the proposal in its annual report last week, as departing RBI governor Raghuram Rajan hands over the reins to close ally Urjit Patel.
The proposal marks a shift in stance by the RBI, which has previously said Islamic finance could be offered through non-bank channels such as investment funds or cooperatives.
That has meant an estimated 180 million Muslims in India, the country's second-largest religious group, have been unable to access Islamic banking because of laws that require banking to be based on interest, which is forbidden in Islam.
The RBI said it would explore introducing interest-free banking products in consultation with the government, a key detail as this opens the prospects of supportive legislation.
"This is definitely a significant development as it is the first time that the RBI has concretely mentioned that it will now work with the government to introduce Islamic banking," said Saif Ahmed, managing partner at Bangaluru-based Infinity Consultants, which specialises in Islamic finance.
"For Islamic banks to function in India, separate parallel legislation or an amendment needs to be passed by Parliament and that can only happen with the active support of the incumbent government."
In 2015, a central bank committee recommended opening a specialised interest-free window to offer cost-plus financing, deferred payment and deferred delivery contracts, a reference to common sharia-compliant contracts such as murabaha and istisna.
Development of Islamic finance has been slow, however, partly because of strong opposition from bureaucrats and politicians from the ruling Hindu-nationalist BJP.
This has long hindered development, although there are signs that India is warming up to Islamic finance.
The government's external lending agency, Exim Bank, said in April it would extend a $100 million credit line to the private sector arm of the Islamic Development Bank.
The Exim Bank's credit line would support foreign buyers of Indian goods and services, with the Saudi-based Islamic Corporation for the Development of the Private Sector acting as the intermediary.