Windfalls and reforms fuel economic boom: Kuwait is riding high on growing business optimism and sound economic fundamentals. But the country's non-oil private sector would clearly benefit from more intensive market liberalisation reforms.

KUWAIT, THE THIRD-LARGEST OF the Gulf Cooperation Council (GCC) six-member economies, is in buoyant shape and prospects for 2006 are favourable.

The removal of a major geopolitical risk from neighbouring Iraq, coupled with recent liberalisation measures have improved business optimism--evident by a surge in private sector investment over the past two years. Real GDP grew at an average annual rate of 7.3% between 2003 and 2005, its fastest pace in 15 years, fuelled primarily by higher crude prices and production.

The oil industry, the emirate's bedrock, contributes about one-half of GDP, plus 90% and 80%, respectively, of total exports and budgetary receipts, the highest ratios in the GCC region. The International Monetary Fund (IMF) noted: "The fastest pace of economic expansion since the 1990 Gulf war, combined with the oil-related terms of trade gains, has boosted per capita income by 34.5% during 2003-04 and helped build up assets for future generations at a record pace." It added: "With oil prices likely to remain firm over the medium-term, Kuwait's medium-term outlook has improved and is likely to remain favourable, supported by large fiscal and current-account surpluses, and low inflation."

The non-oil economy, too, achieved a respectable 5% growth in the three-year period, helped by an expansionary fiscal policy and the spillover effects of the renewed trading with Iraq--benefiting the services industry. One financier told the UK Banker Journal: "The sword of Damocles has been lifted and the glass ceiling over Kuwait has disappeared." The government has agreed in principle to write-off Iraq's $8.2bn debt by 80%, in line with the Paris Club agreement, and offered a $560m grant to fund economic-socio infrastructure projects in the war-torn country.

The public sector, including quasi-governmental organisations, comprises over two-thirds of total GDP, thus providing a major source of consumption, output and jobs within non-oil sectors. The state's revenues in recent years are over-shooting budgetary targets [by wider margins] and hence, increased government consumption and investments have had positive 'multiplier-effects' across the emirate. That, in turn, underpins private sector activity, leading to robust domestic demand and business spending. Kuwait plans to invest about $6bn on its tourism, housing and transport sectors. The construction of a port on Boubiyan Island (a joint public-private venture) should finish by 2008 and a planned North-South GCC train line would contribute to higher intra-regional investment and trade-related activities. Kuwait hopes to reposition its traditional role as gateway to regions in the north and east.

The Kuwait Stock Exchange (KSE) index rose by an impressive 85% during 2005, on top of 102% and 34% during the previous two years, reflecting soaring liquidity, robust corporate earnings and bullish investor sentiment, coupled with some repatriation of offshore private wealth.

The KSE hit record highs of 11,855 last November, with market capitalisation rising to KD37.9bn ($129.6bn). A total of 136 companies are listed on the bourse, of which the top five highest earnings stocks include the National Bank of Kuwait (NBK), the emirate's largest bank, Public Warehousing, Mobile Telecommunications, National Industries Group and Kuwait Finance House. In contrast to Saudi Arabia and UAE, prime Kuwaiti stocks are not overvalued. Global Investment House explained: "The average forward price-to-earnings ratio is only 13.9, which is very cheap by regional standards. There is certainly no overheating."

On the macroeconomic front, the authorities have pursued prudent monetary/fiscal policies, thus underpinning price stability and the exchange rate peg. Consumer price rises have averaged just 1.4% annually over 2000-05, thanks to a stronger currency and subdued import prices. Not surprisingly public finances are exceptionally healthy, as revealed by a recent IMF report: "The central government budgetary position remained strong in 2003/04 and 2004/05 due to significantly higher oil revenues, with annual fiscal surpluses at about 20% of GDP."

NBK projects a record budget surplus of KD6-7bn for fiscal year ending March 2006, before the mandatory 10% allocation of gross revenues to the Reserve Fund for Future Generations. The state's revenues are forecast at KD12.6-13.1bn. The 2005/06 budget was based on a conservative $21 a barrel. In contrast, the price for Kuwaiti Export Crude averaged $47.4, up from $33.8 a barrel in 2004, representing a 40% hike over the year. The government plans to implement a three-year rolling budget from financial year 2006/07.

The Central Bank of Kuwait's (CBK) monetary policy has a tight correlation with the US Federal Reserve Board (Fed). Therefore, the CBK has steadily raised Dinar rates in line with hikes in Fed Funds rate (currently 4.25%) to maintain positive differentials in favour of Dinar-denominated assets, such as Treasury bills, one-year bonds and fixed bank deposits relative to US money rates. The CBK, headed by Sheikh Salem Abdul Aziz Al Sabah, has imposed a ceiling on the credit to deposit ratio. It was implemented in order to address prudential concerns over rapid expansion of credit to the private sector in recent years without a parallel increase in bank deposits. Kuwaiti banks are, however, heavily capitalised and liquid. The capital adequacy ratio remained comfortable (17.3% as of end-September 2004), well above its minimum regulatory level (12%). In 2004-05, asset quality improved further and net profits and returns on equity/total assets also rose significantly.

The external balance of payments outlook is 'rock-solid' underpinned by perennial trade surpluses and substantial inward interest, profits and dividends (IPDs) on offshore assets. In 2005, overseas investment earnings [both official and private] are expected at $5.76bn. Cumulative current-account surpluses totalled an estimated $84.4bn between 2000-05, equivalent to an annualised surplus of $14bn--among the highest in emerging-market economies. State coffers are bolstered by continuing petrodollars windfalls. The US Energy Information Administration projects Kuwait's 2006 oil-exports at $40.3bn, up from $36.9bn in 2005.

Consequently, external reserves of the CBK remain comfortable (eight months of imports). However, foreign reserves (including gold) of $10bn in September 2005 were not a true indicator of Kuwait's international liquidity. The emirate is a major capital exporter and a net creditor to the global banking system. According to the Bank for International Settlements, net overseas bank deposits of Kuwaiti institutions were $13.88bn in June 2005.

The state of Kuwait's credit-ratings [A+] and [A2], assigned by Standard & Poor's and Moody's Investors Service respectively, are on par with most industrialised (OECD) countries. Sound creditworthiness reflects sustained macroeconomic stability, good governance, twin surpluses (the government budget and current-account), manageable domestic debt (17% of GDP in 2005), the sophisticated banking sector and huge net (official) external assets. Foreign banks' lending terms are generally favourable towards 'A-rated' investment-grade sovereigns and corporates.

The bulk of twin surpluses were transferred to increase the assets of the state's overseas portfolios, namely the Reserve Fund for Future Generations and General Reserve Fund, leading to the most rapid asset build-up since the 1990 Gulf war. Total assets of the Kuwait Investment Authority probably exceed $100bn--comprised mostly of benchmark OECD-government bonds (US Treasuries/UK gilts), euro-dollar deposits, international blue-chips, listed on European and US stock exchanges and real estate investments. The earnings on fixed-income securities like dollar-denominated Certificate of Deposits or US Treasury bills have increased in the past two years because of steady hikes in US short-term rates. Also, Kuwait's equity portfolios have risen in value thanks to upturns in global stock markets, led by Wall Street.

The long overdue structural reforms are proceeding, albeit at a slower pace. Since 2000, the government has taken measures to: diversify the economy through deregulations; improve the investment climate (including foreign direct investment); strengthen budget/ expenditure management; and reform an inflexible labour market.

The main objectives are enhancing the non-oil economy's efficiency and growth potential. The current Foreign Direct Investment (FDI) Law permits foreigners to own 100% of local-listed companies, excepting enterprises related to oil or gas exploration/production. As of mid-2005, projects worth $2.4bn were approved under the law and new FDI proposals amounting to $1.8bn were under review by the Ministry of Commerce & Industry.

Whilst a draft privatisation law and amendments to the tax law--to lower corporate tax applying only to foreign businesses from the current--55% to 25% are currently awaiting parliamentary approval. The likely candidates for future sell-offs are Kuwait Airways, Kuwait Aviation Services, Kuwait Public Transport Company, Kuwait Oil Tanker Company, Kuwait Telecom, Petrochemical Industries Company and power/water utilities, among others. Private investment in utilities and oil refining requires market-based pricing of electricity, water and petroleum products. This should ensure an efficient resource allocation and lessen the burden on the budget. Meanwhile, the Kuwaitisation entails training of unskilled nationals and increasing the proportion of Kuwaitis employed in the private sector by setting targets (proportional to the workforce), which non-state companies should observe. Those private companies not complying with the job quotas are excluded from bidding for government contacts. Under this policy, 3,000 nationals have received vocational training, of which 25% were subsequently hired by the private sector.

Observers question the sustainability of the emirate's bloated bureaucracy. Kuwait boasts a very generous welfare system for its nationals [estimated at 950,000]--with free healthcare, education, subsidised power, water and gasoline, as well as housing for married couples. Moreover, the constitution guarantees Kuwaiti nationals public sector jobs for life. Little wonder then that between 90-95% of the national workforce is employed by the civil service and state-owned enterprises, including the parastatals, which also generally pay more than the private sector, which relies mainly on low-paid expatriate workers.

Wages, salaries, subsidies and transfers represented three-fifths of total government expenditure in 2003/04.

The IMF warned: "The current policy of guaranteed employment in the public sector in order to alleviate the unemployment pressure acts as a disincentive for acquiring the skills needed for private sector jobs." It went on to advise the authorities to impose controls on new hiring that would halt the use of the public sector as an employer of last resort, to establish links between wages and productivity and improve targeting of welfare benefits. The Fund also recommended taxation reforms in the context of the planned GCC Monetary Union, including the eventual introduction of a value-added tax (VAT).

Carrying out painful reforms requires active cooperation from the National Assembly and the bureaucracy. However, a conservative parliament--with root support among many government employees and dependents--will not favour radical fiscal measures such as taxation, medical charges, the cutting of consumer subsidies, or mass privatisations leading to potential job losses. In essence, bureaucratic inertia and powerful vested interests could slow the pace of structural reforms, further increasing Kuwait's dependence on its oil sector for budgetary revenues.

The economy should enjoy a healthy pace of GDP growth in the coming years, underpinned by new investments into petroleum and non-oil sectors. Both the current-account and fiscal positions will record sizeable surpluses, albeit at declining levels, because of slightly lower oil prices. This projection, however, assumes that the supply/demand situation could become 'finely balanced' over the medium-term.

Despite the importance of diversification and structural reforms, Kuwait's future lies in optimal development of its hydrocarbons industry--covering both the downstream and upstream sectors. Last year, the government unveiled a major investment programme costing $55bn over the next 15 years aimed at expanding output and processing capacities of energy sector. The Kuwait Petroleum Corporation aims to boost sustainable crude capacity of 4m b/d by 2020 (from present levels of 2.8m b/d); to expand refining capacity to 1.3m b/d by 2010; and increase the petrochemical sector's activities inside and outside Kuwait. The emirate, sole owner of 10% of world's proven reserves, will help preserve stability of crude supplies in the coming decades.

Oil minister, Sheikh Ahmad Al Fahad Al Sabah, commented: "We look forward to seeing the Kuwaiti oil industry achieve more success and prosperity, and attain the position of prominence that it aspires to in the Gulf region and in the world."

Key Macroeconomic Indicators

Projections                         2000     2002     2004

Gross Domestic Product (US$mn)    37,024   35,173   54,700
Share of oil in total GDP (%)       53.4     45.2     55.7
Real GDP growth (%) *                1.9     -0.5      7.2
Real non-oil GDP growth (%) *        1.9      4.3      5.5
Oil production (mn bpd)              2.0     1.75     2.34
Consumer price inflation (%) *       1.6      0.8      1.8
Fiscal balance (%)                  40.8     21.3     22.1
  of GDP ([dagger])
Official discount rate (%)          7.25     3.25     4.75
Kuwait Stock Market index *         -6.5     39.0     33.8
Exchange rate (US$1 per KD) **      3.26     3.29     3.39
Balance of Payments and External Assets (US$mn)
Exports (FOB)                     19,478   15,366   30,221
Oil as (%) of total exports         93.4     91.7     92.3
Imports (FOB)                      6,451    8,124   10,920
Trade balance                     13,027    7,242   19,301
Current-Account                   14,672    4,251   18,884
Current-Account (%) of GDP          39.6     12.1     34.5
Foreign exchange reserves          7,082    9,208    8,242
Import-Coverage **                  13.0     13.5      9.0
Central Bank's foreign assets      7,033    9,041    8,155
Deposits-in-OECD-Banks            18,303   22,020   27,751

Projections                                2005      2006

Gross Domestic Product (US$mn)           61,700    67,800
Share of oil in total GDP (%)              56.4
Real GDP growth (%) *                       5.2   3.6-4.0
Real non-oil GDP growth (%) *               4.7       4.5
Oil production (mn bpd)                     2.5
Consumer price inflation (%) *              1.8       1.8
Fiscal balance (%)                         24.7      20.9
  of GDP ([dagger])
Official discount rate (%)            6.0 [Nov]
Kuwait Stock Market index *                85.0
Exchange rate (US$1 per KD) **             3.42
Balance of Payments and External Assets (US$mn)
Exports (FOB)                            43,868    43,560
Oil as (%) of total exports                94.0      94.0
Imports (FOB)                            12,230    13,698
Trade balance                            31,638    29,862
Current-Account                          30,949    30,148
Current-Account (%) of GDP                 50.1      44.4
Foreign exchange reserves           8,893 [Sep]
Import-Coverage **                          8.5
Central Bank's foreign assets      12,076 [Sep]
Deposits-in-OECD-Banks            27,753 [June]

* Annual % change; ([dagger]) including overseas investment income;
** The Kuwaiti dinar is officially pegged to the US dollar since
January 2003; ** Months. Sources: International Financial Statistics,
IMF, Kuwaiti authorities, Economist Intelligence Unit, Business
Monitor International, National Bank Kuwait and Bank for International
Settlements. Population: 2.8m (2004); Area: 17,818sq km. Hydrocarbons
reserves: Crude oil [101.5bn barrels] and Natural gas
[1.56 trillion cubic feet].