Kuwait may be slow with fiscal reforms, but it can afford to take its time
editor's pickThursday 08, November 2018
Kuwait packs a lot of financial punch for its size. It boasts the world’s oldest sovereign wealth fund, the world’s most expensive currency and is the seventh richest country in the world per capita. It’s easy to forget that these economic accolades haven’t simply been bought with black gold. In what is referred to as its golden era from the 1940s to the 1980s, Kuwait’s liberal values cradled a respected theatre industry, the freest press in the Arab world and a literary renaissance in the Middle East.
As creator of the world’s first Sovereign Wealth Fund and the first stock exchange in the Gulf, Kuwait was also a posterchild for diversification away from oil. It’s easy to forget because today Kuwait derives around 55 per cent of its GDP, more than 90 per cent of its exports, and about 90 per cent of fiscal receipts from hydrocarbon products. Frictions between a cabinet handpicked by the Emir and a democratically elected parliament has stunted Kuwait’s diversification efforts, leaving it lagging behind its GCC peers.
The squabbles that have delayed Kuwait’s fiscal reforms have left the country economically paralysed. The tendering process of several public private partnerships stalled in 2017, and the planned introduction of VAT has been pushed back to 2021. The parliament also delayed the passing of a new debt law after the previous one expired in October 2017, blocking any debt issuance thus far in 2018. At the end of 2017, Kuwait’s entire cabinet resigned rounding off a year of mixed fortunes. Overall, real GDP growth contracted an alarming 2.9 per cent in 2017, according to S&P.
The oil sector contracted by 7.2 per cent; however, growth in the non-oil sector held up at 2.2 per cent, as households and government relaxed their purse strings and began to spend. Kuwait has carried over many of these positive themes into 2018, however the country’s financing needs remain large and deeper reforms are needed to sustain them. While Kuwait has sound financial buffers, keeping its population in the lifestyle to which it has become accustomed isn’t cheap. Kuwait’s citizens have enjoyed a generous welfare state and a prominent public sector that employs 80 per cent of the national workforce. Kuwaiti authorities would rather watch their reserves slowly erode than break that social contract.
Luckily for Kuwait, some savvy investments decades ago means it can afford to take its time. Sheikh Abdullah Al-Salem set up the Kuwaiti Investment Authority (KIA) in 1953, which is now thought to have assets of $580 billion, or 460 per cent of GDP, although its performance is not disclosed. The Reserve for Future Generations Fund (RFFG) was created in 1976 to provide financial security when Kuwait’s oil reserves finally dry up. It was seeded with a deposit of a mere few hundred thousand pounds in the Bank of England; today it is thought to be worth $420 billion. To sustain the fund’s growth, 10 per cent of all oil revenues are siphoned off and transferred into it.
The General Reserve Fund holds the accumulated government surpluses after transfers to the RFFG; the government has been tapping this fund for financing, and its value is thought to have fallen for the fourth year in a row, according to Fitch. While the RFFG would allow Kuwait to sustain current deficit levels for decades, Fitch estimates that the GRF could sustain the country for five years before it runs out. “We estimate that Kuwait's net external asset position will remain very strong at more than 6x current account payments over 2018-2021,” S&P said. “Moreover, we project that the current account receipts plus usable reserves will cover the country's gross external financing needs over the next four years.”
Banking is bright
These nest eggs have given Kuwait ample space to smooth fiscal consolidation, and Kuwait’s banking system has reaped the rewards of this financial security. According to the IMF, resilient non-oil activity and strong financial sector oversight has kept the banking system sound. High capitalisation, steady profitability and good asset quality characterise Kuwait’s financial sector. Moody’s said that Kuwait’s banks will be supported by steady non-oil economic growth and solid financial fundamentals over the next year. The rating agency expects annual domestic credit growth of around six per cent over the next 12 to 18 months.
Household credit growth will be the key driver on the back improving economic sentiment and steady employment growth. While corporate credit growth will be slower, due to corporate repayments and moderation in the development project space, banks will still find opportunities for corporate credit and non-cash business arising from substantial active projects, Moody’s said. "Non-performing loans levels will stabilise at around two per cent of gross loans amid favourable domestic conditions," said Alexios Philippides, an Assistant Vice President and analyst at Moody's.
"We also believe that banks have cleaned up their portfolios before this year's implementation of IFRS 9 accounting standards by mobilising the large pool of general provisions accumulated in recent years, which will help limit impairments going forward." The main risks as far as the rating agency is concerned are adverse domestic political and geopolitical developments or renewed weakness in oil prices. Any of these factors could flatten confidence and subdue equity markets and the real estate sector, to which banks are exposed, potentially reducing business growth and pressuring banks' asset quality. Kuwaiti banks, however, maintain strong loss absorption buffers, with the system's Basel III Tier 1 capital ratio at 15.8 per cent as of December 2017.
The rating agency also says that significant general provisions will allow banks to migrate to IFRS 9 without a negative impact on capital. Moody's also expects that growth in deposits together with current excess liquidity will allow banks to grow their loans without increasing their reliance on confidence-sensitive market funding over the next 12-18-months. The CBK has been proactive in improving supervision and regulation, the IMF noted, although the sector could do more to enhance its crisis management and liquidity forecasting frameworks.
Nonetheless, it seems Kuwait’s banks won’t have too much to worry about. While an initial drop in confidence in 2014 soured activity in the nonoil sectors, there have been signs of recovery. Moody's forecasts non-oil GDP growth of 3.5 per cent in 2018 and 4.0 per cent in 2019, driven by growing government spending. Non-oil activity expanded by 2.8 per cent in the first quarter of this year, according to World Bank data, which helped to lift aggregate GDP growth to 1.6 per cent—the first positive in five quarters. However, out of all the countries in the GCC, Kuwait remains the most dependent on hydrocarbons and oil will continue to have the biggest impact on its economy. Luckily, for the foreseeable future, that impact is likely to be positive. Kuwait is the fifth largest OPEC oil producer, and one of the few OPEC members with spare oil production capacity. Plans to invest $115 billion in the oil sector over the next five years should further boost oil production, according to the World Bank.
The recovery in oil prices over the past year, which are close to three and- a-half year highs, and rising public sector employment has also bolstered household spending and sentiment, as reflected in buoyant retail spending. Following a correction in 2016 and 2017, real estate prices have also stabilised. Rising oil prices are providing much relief to Kuwait’s finances. While lower oil prices since 2014 have caused Kuwait's central government balance to remain deep in deficit, the country is becoming fiscally fitter every year. During 2017 the central government deficit narrowed to 14.6 per cent of GDP, from close to 18 per cent in 2016, owing to higher oil revenues. S&P estimates that temporarily higher oil prices in 2018 will support a further reduction in the deficit to 10.6 per cent of GDP in fiscal 2018.
The new black
However, Kuwait can’t afford to be carried by higher oil process. Over the next few years, several projects in power, infrastructure, and housing, currently in various stages of implementation, are expected to come to fruition. In March, the government unveiled its Northern Gulf Gateway project, which aims to add $220 billion to the country's GDP, attract up to $200 billion in foreign direct investment creates 400,000 knowledge-based jobs and tempt 3-5 million visitors to Kuwait. The project would fuse Kuwait into China’s Belt and Road Initiative, a 21st Century take on the Silk Road made up of a “belt” of overland corridors and a maritime “road” of shipping lanes. Kuwait is the first GCC country to sign up to China’s efforts to tie Southeast Asia to Eastern Europe and Africa, a swath of the globe that accounts for 71 countries, half the world’s population and a quarter of global GDP.
At the epicentre, Kuwait has the opportunity to become a major commercial centre and a base for a network of railways which start from China and pass through Central Asia and Gulf states. China could be a powerful ally as Kuwait seeks to model itself on Hong Kong under its revised 2035 plan, the aim of which is to become a leading regional financial, commercial and cultural hub by 2035. The plan involves transforming five islands into economic zones with an investment value of up to $160 billion. They would also double as tourist attractions that would hopefully entice investments in commercial and residential complexes as well as infrastructure.
The best laid plans
The New Kuwait Vision 2035 is actually a second draft of a plan that was first released in 2010, and quickly thwarted by political gridlock, geopolitical tensions and overly-ambitious plans to compete with established financial centres in the region. It was quickly binned when Sheikh Nasser resigned as Prime Minister in 2011. The new plan faces the same hurdles as geopolitical tensions remain high, policymaking continues to be delayed by domestic bickering and Kuwait’s never-ending red tape still threatens to deter investors. For the same reasons, there is a worry that the Government's policy response to its current challenges will be limited. Higher oil prices and large fiscal buffers provide a dangerous incentive to keep the status quo. “We expect reform momentum aimed at diversifying revenues will slow further in the context of higher oil prices during 2018,” S&P said.
“We expect the government to focus on moderating expenditure growth by somewhat limiting new employees in the public sector, strictly enforcing current welfare policies to reduce overspending, and charging nominal fees to cover the cost of providing services to its citizens.” The authorities also plan to introduce excise taxes on certain goods in 2019. The government intends to divest underutilised assets and privatise around 40 assets over the next 25 years. It is currently studying the feasibility of privatising the North Shuaiba power plant, fixed line and broadband telecoms infrastructure, the Ministry of Electricity and Water Central Workshop, and the national stock exchange.
However, “Notwithstanding plans to further curtail current spending and introduce revenue measures, including a value-added tax, more ambitious efforts are needed to bring the fiscal balance closer to levels implied by intergenerational equity considerations, reduce financing needs more rapidly, and create space for growth enhancing capital outlays,” the IMF said. Kuwait may currently boast the strongest finances among GCC countries, but it cannot afford to become complacent. Kuwait was once a trailblazer for Arab economies that it now lags behind. Unless it rediscovers its pioneering spirit and rises above petit squabbles, it will always be playing catch-up with countries it once inspired.