Journal Issue

Kuwait: Selected Issues and Statistical Appendix

International Monetary Fund
Published Date:
July 2005
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IV. Are Lending Rate Ceilings Hampering the Development of Small- and Medium-Sized Enterprises in Kuwait?29

A. Introduction

73. The Kuwaiti banking sector shows adequate levels of capitalization, asset quality, and profitability. Overall soundness is supported by a comprehensive prudential regulation and supervisory framework that conforms in most respects to international standards. As concluded by the recent FSAP (IMF, 2004), it could withstand significant shocks to interest rates, exchange rate, liquidity, and asset quality. It has played a dynamic role in promoting private sector development and contributed to the country’s impressive recovery from the economic damage caused by the 1990–91 war. Kuwait remains, nonetheless, highly dependent on oil, and its economic diversification has advanced at a somewhat slow pace, with reversals caused by oil market developments.

74. The purpose of this paper is to analyze whether the existence of lending interest rate ceilings is hampering the development of a vibrant small- and medium-size enterprises (SMEs) sector which may help invigorate non-oil economic growth and employment. We conclude that, given the data available, lending rate ceilings in Kuwait do not appear to be a major deterrent in the creation and development of SMEs. This is so because, despite the likely binding effect of the ceilings, the public sector provides ample financing under concessional conditions to all SMEs that meet some predetermined criteria. Furthermore, despite the virtual nonexistence of financial products targeted to the SMEs in the traditional banking sector, Islamic banks provide an effective funding channel which goes well beyond the traditional limitations of the banking system in SME financing. Nonetheless, the removal of the remaining ceilings may contribute at the margin to the development of SMEs and provide additional flexibility to the product development and pricing practices of banks.

75. This paper does not analyze the broader impact of lending rate ceilings on economic growth. The authorities report that the vast majority of corporate loans are extended at rates below the ceilings, which supports the hypothesis that, as they stand, lending rate ceilings in Kuwait are not generally binding. It follows that their impact on overall economic growth has to be relatively small, except for credit to customers which traditionally are priced above market average. Thus, this section focuses on whether lending rate ceilings affect the SME sector, which is one of the more relevant groups of customers generally priced above corporate lending average rates, and one of the main drivers for job creation.30

76. The remainder of the chapter is organized as follows. Section B summarizes the theoretical background explaining the relationship between financial repression and economic growth. Section C reviews the current status of interest rate ceilings in the MENA region. Section D discusses the recent structure of interest rate ceilings in Kuwait and their impact on SMEs’ access to financing. The conclusions of the study and policy recommendations are presented in section E.

B. Theoretical Background

77. Lending rate ceilings, as an instrument of financial repression, have been found to have a negative effect on economic growth, both through its credit rationing effect and the distortion in the allocation of financial resources (Box IV.1). Applying the analytical framework used in the empirical financial repression literature to assess the specific impact of lending rate ceilings on SMEs has proved elusive so far. Only partial and descriptive papers have been produced, since econometric analysis is hampered by the difficulty in separating the effects of the ceilings from the effects of other administrative measures that are usually present simultaneously in financially repressed environments, and by the lack of financial information on the SMEs and/or disaggregated banks’ loan portfolio.

78. Lending rate ceilings make harder access to credit for riskier and smaller customers/sectors. Since credit is not a homogeneous product, credit extended at any particular point in time in a particular market is priced differently according to its term, amount, and credit risk of the borrower, among other factors. It follows that, under lending rate ceilings, riskier projects requiring higher interest rates will be affected first by the rationing effect of the ceiling. Similarly, micro and retail credit entail large unit operating costs, which are partially compensated through higher interest rates. Thus, access to credit by companies and/or economic sectors with higher credit risk (as measured by the statistical probability of default), such as agriculture, and by retail or micro borrowers, is more likely to be hampered by the existence of lending rate ceilings, unless specific administrative mechanisms are put in place to meet for their financial needs.31 Since SMEs are the engine of job creation in most countries,32 lending rate ceilings may constitute a serious handicap for promoting employment in the private sector.

Box IV.1.Financial Repression and Economic Growth: Theoretical Background

The existence of interest rate ceilings is usually associated with financial repression, leading to financial underdevelopment and lower economic growth.33 In the McKinnon/Shaw framework, interest rate ceilings inhibit financial development mainly through keeping real interest rates below their market level. This, in turn, leads to the rationing of credit that affects negatively economic growth. Also, growth is hampered by the sub-optimal allocation of financial resources caused by the elimination of the price discrimination system that allows financial markets to allocate financial resources to those investment projects with the highest returns.

Financial repression, defined as the set of policies, laws, regulations, taxes, qualitative and quantitative restrictions and controls imposed by the government which directly interferes with the allocation of financial resources and the price discovery function of financial markets, was common prior to the 1970s. According to Roubini and Sala-i-Martin (1995, p. 276) financial repression was favored on the basis that (i) anti-usury laws were needed for social reasons; (ii) tight control and regulation of the banking system was considered necessary to ensure banking soundness and proper monetary policy transmission mechanism; (iii) determining the allocation of financial resources to certain sectors or projects was a policy issue to be decided according to the government’s notion of socially “strategic” sectors or projects; and (iv) maintaining interest rates below market rates reduced the cost of servicing government debts.

Empirical research (Roubini and Sala-i-Martin, 1992 and 1995) suggests three main channels through which financial repression impacts negatively on economic growth: (i) productivity of investments is negatively affected; (ii) the overall level of investment and savings in the economy is reduced; and (iii) intermediation costs are increased. Recent research has found that the relationship between financial liberalization and economic growth is more relevant via the effect of liberalization on the efficiency of the financial system to allocate financial resources than via its effect on financial deepening. Increased financial system efficiency has been measured through higher access to external finance (Demigurc-Kunt and Maksimovic, 1996, and Rajan and Zingales, 1998), lower default rates (Jayaratne and Strahan, 1996), enhanced total factor productivity (Beck, Levine and Loayza, 2000), and lower variation in expected returns to investment (Abiad, Oomes and Ueda, 2004).

79. Other negative effects of interest rate ceilings include competitive disadvantages for some intermediaries, regulatory arbitrage, and fraud. Since interest rate ceilings seldom affect all financial intermediaries and products (assets), they usually result in an unleveled playing field. Financial institutions are particularly creative in developing alternative ways of financing their customers and attract deposits which circumvent interest rate ceilings. The opacity of this type of arrangements and their frequently unregulated nature increase the chances for fraud.34

80. As a monetary policy tool, interest rate ceilings and other direct instruments have been phased out by most industrial countries since the 1970s. In progressively liberalized economies with full convertibility and capital mobility, direct instruments became increasingly ineffective, leading to inefficiencies and disintermediation.35 Careful sequencing of the financial liberalization process and the adoption of accompanying reforms, including institutional strengthening in the financial supervisory and monetary authorities, are critical elements for a successful elimination of interest rate ceilings and other financial repression measures (Alexander, Baliño and Enoch, 1995). Financial liberalization without proper sequencing and concomitant reforms may easily result in financial instability.

C. Interest Rate Ceilings: Selected Cases

Interest rate ceilings in the MENA region

81. Liberalization of financial systems, including removal of interest rate ceilings, has progressed in the MENA region during the last decade, albeit at a slower pace than in other parts of the world. The current status of interest rate ceilings in the region is summarized in Table IV.1. Out of the 20 countries considered in the MENA region, 10 had completely liberalized interest rates de facto, while the remaining 10 still present a number of limits to the free market determination of interest rates, ranging from certain degrees of institutionalized collusion (mainly among large public sector banks) to the administrative determination of lending and deposit interest rates.

Table IV.1.Interest Rate Ceilings in the MENA Region
Are Interest Rates Liberalized?
AlgeriaYes, de jure. Public banks convene to discuss interest rates.
EgyptYes, de jure. Social considerations by public banks result in downward rigidity of deposit rates.
Iran, Islamic Rep. ofNo
KuwaitPartially. Ceilings on bank lending rates remain, tied to discount rate.
LibyaNo. Interest rates on deposits and loans unchanged since 1994.
MauritaniaPartially. Floor is set on some savings rates and legal ceiling on lending rates.
OmanPartially. Interest rates on personal loans capped at 12 percent.
Saudi ArabiaYes
Syrian Arab RepublicNo. Interest rates unchanged since 1984.
TunisiaPartial. Some deposits remain regulated.
United Arab EmiratesYes
Yemen, Rep.Partial. A minimum benchmark rate for savings deposits is set administratively.

82. There is a wide dispersion in the way the interest rate ceilings are calculated, the scope of the banking system affected by the rates, and the resulting maximum marginal intermediation spreads (Table IV.2).36 Out of the eight countries with formal ceilings in the MENA region, Tunisia, Yemen, and Kuwait present relatively low distortions through interest rate ceilings, while Libya, Syria, and Iran’s ceilings introduce a substantial degree of financial repression. Although Kuwait’s maximum marginal intermediation spread is smaller than in some other countries (such as Mauritania), its lower inflation results in a higher spread in real terms.

Table IV.2.MENA: Explicit Interest Rate Ceilings

(In annual percent, as of end-December 2004) 1/

Discount rate 2/14.04.759/4.011.015/1.25 - 7.519/n.a.5.026/n.a.
Maximum lending rate13.5 - 18.06/4.75 - 8.7510/2.0 - 6.512/21.016/11.020/4.0 - 9.523/free27/free
Average lending rate16.77/6.74n.a.15.07.8n.a.n.a.15.0
T-bill auction rate 3/17.00.855.513/7.20.521/n.a.5.214.4
Minimum deposits rate7.0 - 17.08/free0.0 - 5.014/8.017/n.a.2.0 - 6.524/2.0 - 5.2528/13.029/
Average deposit raten.a.3.26n.a.5.51.1n.a.n.a.n.a.
Spread between average lending and deposit ratesn.a.3.48n.a.9.56.7n.a.n.a.n.a.
Maximum marginal intermediation spread 4/-0.5 - 4.00 - 4-2 - 2.510.03.5 - 9.7522/-2.5 - 7.525/freen.a.
Memorandum items
CPI growth (2004 average)15.01.8-
Sources: National authorities and Fund staff estimates.

83. Jbili, Kramarenko, and Bailén (2005) show evidence on the impact of financial repression on the financial intermediation function of banks in Iran. The authors do not find evidence of causality between financial repression and economic growth in Iran, and hypothesize that the inefficiencies in the financial sector may be masking this relationship. However, they find indirect evidence of the negative effects of interest ceiling on the development of public banks. The four private commercial banks in the country, which are not subject to controls on rates of return and do not benefit from the implicit guarantee of deposits affecting public banks, show higher costs of funds, including deposit and lending rates, as expected. However, despite these pricing and guarantee disadvantages, private banks have increased their market share, due in part to the credit rationing resulting from ceilings imposed on state-owned banks.

Other country case studies

84. Evidence on the impact of financial liberalization on economic growth is mixed. The effect of interest rate ceilings on economic growth is normally measured together with that of the whole set of financial repression measures. Most country case studies focus on the effect of eliminating financial repression measures (i.e., financial liberalization) on economic growth. Frequent episodes of financial crisis followed the liberalization of the financial system, making it clear that financial liberalization introduced risks for financial stability. Thus, earlier positive assessments of the impact of financial liberalization on economic growth were later tuned down or even completely reversed after economic growth was severely affected by financial instability. This was the case, for instance, for South East Asian countries after 1997. However, the evidence tends to point that financial instability could be prevented through an appropriate sequencing of the liberalization and parallel institutional strengthening measures (Box IV.2).

D. Interest Rate Ceilings in Kuwait

Current structure of interest rate ceilings

85. The Kuwaiti authorities are engaged in a process of financial sector liberalization and have already eliminated most of the rigid interest rate structure that characterized the Kuwaiti market of the 1970s and 1980s, including administrative ceilings and floors on various categories of deposits and loans.37 As discussed in the staff report for the 2004 Article IV consultation, the latest steps in this process include the elimination of restrictions to the opening of foreign banks’ branches and regulatory improvements equalizing the prudential oversight of local commercial and Islamic banks. As part of this process, mandatory minimum interest rates for time and saving deposits were eliminated by the decision of the Central Bank of Kuwait (CBK) issued in January 1995. Also, charges and commissions collected by banks against rendering banking services (henceforth banking fees) were also liberalized by the CBK decision issued in January 1995.

Box IV.2.Selected Country Case Studies: The Impact of Financial Liberalization

Greece. Voridis (1993) estimates the effect of interest rate ceilings on private sector investment in Greece from 1960 to 1985. He concludes that the availability of bank credit to the private sector has a significant positive effect on private sector investment. The negative correlation between lending rates and the level of private sector investment led to the conclusion that credit rationing, imposed through interest rate ceilings, had a lagged negative effect on investment.

India. Imam (1984) estimates the welfare cost of interest rate ceilings in India through an intertemporal general equilibrium model. The results of the numerical exercise show that national income and consumption could be increased by about 10 percent by the removal of the ceilings. Kunal Sen and Vaidya (1998) positively assess the experience of financial liberalization in India, and attribute its success to the adequate sequencing of measures within a gradualist approach to liberalization, and to adequate concomitant reforms including previous real sector reforms.

The United States of America (U.S.A.)Jayaratne and Strahan (1996) test the effects of the deregulation of intrastate branching restrictions in the U.S. between 1972 and 1993 on economic growth. Restricting banks’ branch network expansion has negative effects on the efficiency of financial intermediation through market segmentation and reduced competition. Although the credit rationing effects of interest rate ceilings are not produced by restrictions on branching, both financial repression measures share their negative impact on intermediation costs, the level of savings and investments, and the effective management of risks. The paper finds evidence that banks improved their credit risk screening and monitoring practices after removal of the branching restrictions. This increased efficiency is deemed to be the channel explaining the acceleration of economic growth following intrastate branching reform.

Other. Alexander, Baliño and Enoch (1995) provide statistical evidence on the positive effects of phasing out direct monetary policy instruments, including interest rate ceilings, on the efficiency in the financial sector and on the degree of monetary control, for 14 countries. In addition, they provide a detailed account of the policy measures undertaken, the concomitant reforms, and the sequencing of the changes for eight countries, including Chile, Egypt, Ghana, Indonesia, Mexico, New Zealand, and Poland. In all but three countries the efficiency of financial intermediation increased after phasing out of direct monetary policy instruments, as proxied by the narrowing of intermediation spreads. Also, the variability of the money multiplier fell substantially between the transition period and after completing the phasing out of direct instruments. Some 70 percent of the countries in the sample experienced lower interest rate volatility, implying a potential improvement in monetary control.

Alawode (2003) extensive survey concludes that the results of financial liberalization have been mixed in developing countries. While negative effects seem to be the norm in African countries (Senegal, Nigeria, and Uganda), mixed results are reported in the Middle East and Asian regions, where increases in financial instability were predominant in Turkey and the Philippines, while successful experiences were reported in Malaysia, Korea, Sri Lanka and Indonesia. The assessment of the effects of financial liberalization on Asian countries, however, changed radically after 1997. In Latin America, Argentina, Uruguay and Colombia were among the cases in which financial liberalization led to instability, while in Mexico positive effects on intermediation efficiency were assessed. In Chile, while initially contributing to financial instability, financial liberalization is deemed to have had a long-term positive effect on economic growth. It is worth mentioning that in most cases where financial liberalization led to instability, the studies link this failure with either the inadequate sequencing of the liberalization process, the inconsistent implementation of the reforms, frequent policy reversals, and a lack of concomitant measures (mainly the strengthening of prudential regulation and supervision).

86. Interest rate ceilings on lending rates are still in effect in Kuwait. Maximum limits on interest rates on Kuwaiti dinars (KD) lending are linked to the CBK-fixed discount rate within specific spreads, which have remained unchanged since their application on April 25, 1993. The maximum marginal intermediation spread ranges from slightly above zero38 (for consumer loans) to 4 percent (loans and overdrafts with over one-year maturity). The ceilings are expressed in nominal rates and do not include banking fees and commissions (Figure IV.1 and Table IV.3).

Figure IV.1.Kuwait - Lending Rate Ceilings

(In percent per year)
Table IV.3.Kuwait: Interest Rate Ceilings, 1993–2005(In percent per annum)
Maximum lending ratesLending margin over discount rate
Valid SinceDiscount rateConsumer loansCredit one year or lessCredit more than one yearCredit one year or lessCredit more than one year
Source: Central Bank of Kuwait.

87. Interest rate ceilings do not apply to Islamic financial institutions. According to the Islamic finance principles, the return on financial instruments of Islamic financial institutions must be linked to purchase and resale of goods (and provision of services) or to profit and loss sharing on investments. Since Islamic financial institutions do not charge ex-ante pre-set interest rates, the interest rate ceilings as defined in Kuwait do not apply to the return obtained in their financial intermediation operations.

88. Although the monetary authorities agree that lending rate ceilings are no longer needed, their elimination has proven not feasible so far. The 2004 Financial Sector Stability Assessment Report for Kuwait (FSSA), recommended easing or removing the lending rate ceilings in order to enable lenders to better price the risks of lending, including to SMEs in particular for two reasons: (i) to better support private sector growth; and (ii) to further strengthen its otherwise effective monetary operations.39 The authorities agree with this recommendation. However, since the ceiling on lending rates remains a legal requirement under Article 111 of the Commercial Law, its removal will require a legal amendment entailing a delicate political process.

89. After several reported incidents of charges of bank fees considered to be abusive, the CBK decided to introduce a pre-approval requirement for bank fees in 2002. This has resulted, de facto, on a ceiling for bank fees, since the maximum amount of the fee for each specific bank service in all banks within the system approved by CBK is the same. In practice, therefore, banks cannot charge fees freely in order to achieve the all-in yield of lending operations required for servicing the SMEs or other high risk or high cost customers.

90. A number of measures taken primarily for prudential purposes, and certain administrative instruments of monetary policy, also introduce additional rigidities in the market allocation of financial resources. Specifically, the CBK imposes several quantitative ceilings to specific types of credit (consumer and installment)40 and, although no reserve requirements are imposed, a liquidity requirement and a maturity ladder are used to regulate bank liquidity.41 Mainly for prudential reasons, in July 2004 the CBK introduced a ceiling of 80 percent on the ratio of credit (net of provisions) to total deposits, which Kuwaiti banks are required to meet by June 2005. Although the average value of the ratio as of end-September 2004 was 78.6 percent, all but three banks in the system had ratios above the 80 percent ceiling. The existence of these administrative measures does not appear to have had a significant impact on bank profitability, which has been growing continuously during the last decade.42

Are lending rate ceilings binding?

91. In a liberalized financial system, banks price their loans individually, factoring in several critical elements. Considering a stylized model of bank credit pricing policies, lending rates for a particular bank are based on the cost of funds, operating expenses, and risk of the operation.43 Interest rates applied to a particular operation also depend on the cross-subsidization policies that the bank may consider and, finally, on the specific competitive conditions of the market, which will determine the profit margin for the bank.

92. Financial liberalization and competition are critical to the price discovery function of financial markets. At any given point in time, in a competitive, liberalized financial market, the cost of funds relevant for all operations of the same maturity is identical and equal to the average cost of funds of the bank for that particular maturity.44 Operating expenses, however, vary according to the nature of the operation and the customer. Also, the volume of operations may affect operating expenses when economy of scale is present. In addition to the maturity, type of operation and customer, the risk of the operation also varies according to a number of institutional factors including quality of financial statements, existence and quality of property registries, contract enforcement and foreclosure procedures. Finally, although cross-subsidization policies may be present for cultural or historical reasons,45 they tend to be less relevant in liberalized financial systems where banks are forced to compete in every line of products.

93. Lending ceilings will be binding when the lending rates resulting from applying a bank’s credit pricing policies are higher than the maximum rates allowed. When, as in the case of Kuwait, lending ceilings are differentiated by types of lending products, the ceilings will be binding if the bank rate for a particular type of product is higher than the ceiling.46 Since this rate is determined also by factors other than the type of product and the cost of funds,47 it may well happen that the ceilings may be binding for products and customers with higher operating costs and risk, while, at the same time, the pricing for operations and customers with lower operating costs and risk may not be affected.

94. Indirect indicators are needed to assess whether lending rate ceilings are binding for certain operations and customers, since it is impossible in practice to know the theoretical prices for each operation and customer of the banks. Interest rate spreads and the distribution of loans according to interest rate are the two indirect measures available in Kuwait. In addition, further information is obtained from the actual banking practices reported by senior bank officers and by recent regulatory changes.

Interest rate spreads

95. Available data suggests that lending rate ceilings have not been binding for the average corporate loan. The average intermediation spread in the Kuwaiti banking sector fluctuates around 3 percent. The marginal cost of funds (the CBK discount rate) has been traditionally between 0.5 and 1.5 percentage points above the average deposit rate, which could be used as a proxy for the average cost of funds.48 Since the maximum marginal intermediation spread is fixed between 2.5 and 4 percentage points, depending on the maturity of the operation (other than consumer credit), average lending rates have been traditionally below the lending rate ceilings (Figure IV.2). Thus, it is possible to conclude that, unless a disproportionate amount of operations had maturities of one year or less, the ceilings have not been binding for the average operation, maturity, amount and customer.

Figure IV.2.Kuwait: Lending Ceilings and Average Rates

(Annual Percentage)

96. However, the ceilings seem to be binding for the SMEs. The ceilings are very close to the average rate effectively used by banks, with only 1.5 to 2 percentage points of spread in the best of the cases to deal with operations priced above the average. The average interest rates charged to the SME sector in some European markets ranges from 1 to 3 percentage points above the average lending rates of the banking sector.49 This spread is substantially higher in less matured financial markets, where the institutional factors mentioned above would increase the risk of the operation. Thus, the average spread in the lending rate of small enterprises is of about 5 percentage points in Chile, 6.5 percentage points in El Salvador, and 16 percentage points in Peru.50 Furthermore, SMEs start-ups are usually charged a particularly high risk premium, since there is no previous information on which to base the assessment of the financial flows of the company and no track record of management quality, competitive position, and other key indicators.51 Therefore, it is likely that the lending ceilings in Kuwait are binding at least for those SMEs (and other customers and types of operations) with relatively high risk.52

Interest rate distribution of loans

97. The hypothesis that lending ceilings are binding for the SMEs is reinforced by the analysis of the limited data available on the distribution of total KD loans per clusters of interest rates.53 About one-third of total loans were granted at the maximum lending rate, at least for the period June 2002–July 2004. During the period December 2001–December 2004, an average of between 45 and 50 percent of total KD loans carried interest rates below the short-term lending ceiling (Figure IV.3). This could be interpreted as a rough indicator that lending rate ceilings have been binding for about 30 to 50 percent of total loans. Including consumer loans (all of them granted at the maximum ceiling equal to the discount rate),54 these percentages increase to about 40 to 60 percent of total loans. Bank practitioners report that the rate applied for personal loans55 cluster at about the maximum lending rates. Since about 40 percent of the total amount of KD loans correspond to personal loans, it is possible to conclude that about 20 percent of total credit (representing about one-third of total credit to the corporate sector) is granted to enterprises at the maximum lending rate.

Figure IV.3:Volume of Credit per Interest Rate

(In percent of total KD credit)

Bank practices and regulatory changes

98. SMEs have limited access to commercial banks in Kuwait. Several commercial bank officers reported to the 2004 Article IV mission that their institutions did not engage in simple (“plain-vanilla”) credit relationships with SMEs, and rarely maintain simple credit relationships with large enterprises. Only those companies which demanded a comprehensive set of financial products and services from the banks, allowing the possibility to cross-subsidize loans with income from services, off-balance sheet products, and off-shore financing, were considered as profitable customers, thus excluding most SMEs.

99. The findings of a survey of 483 SMEs conducted in 2000 by Kuwait University and the World Bank provide further evidence of SME difficulties in accessing to commercial banks credit. “Kuwaiti banks are not prepared to extend term loans to SMEs in significant volumes. This seems to be due to interest rate caps that prevent banks from pricing loans to cover actual risk and to a prevailing culture of lending mainly for trade and for personal consumption” (Webster, 2002, p.4).

100. The introduction of the 80 percent ceiling on the net credit to the nongovernmental sector to total deposits has increased the chances that lending rate ceilings are binding for a larger number of operations. This is due to the market segmentation caused by this measure.56 Due to the increased competition for large, long-term deposits, the marginal deposit rate has been pushed well above the CBK’s discount rate.57 Therefore, the marginal cost of funds qualifying to be onlent to the private sector, is no longer the CBK’s rediscount rate, but the marginal deposit rate. Since, according to the latest data available, the marginal deposit rate was over 0.75 percentage point of the discount rate for some banks, the effective maximum marginal intermediation spread for Kuwaiti banks could have been reduced from zero to about -0.75 percent for consumer loans, at the bottom of the range, and from 4 to 3.25 percent for loans over one year, at the top of the ceiling rage. The authorities are considering exempting some large investment operations considered strategic for the country from the ceiling on the ratio of net loans to total deposits, but this will likely not affect financing to SMEs. As a result, the probability has increased that market-determined pricing for corporate customers (and particularly for SMEs) would result in interest rates above the lending rate ceilings.

101. However, since the authorities consider the ceiling on the ratio of net loans to total deposits as temporary, and intend to remove it once domestic credit expansion is in line with the expansion of the domestic deposit base, its effect on the relevance of lending rate ceilings is only transitory. Furthermore, the rapid increase of the CBK’s discount rate since the introduction of the ceiling on the ratio of net loans to total deposits will also alleviate the problem by containing demand for credit at the higher interest rates.

Alternative sources of financing for SMEs

102. Despite the likely binding effect of the lending rate ceilings on SME financing by Kuwaiti commercial banks, there is little evidence of shortage of funding for Kuwaiti’s SMEs. Furthermore, access to finance and to venture capital for most SMEs appear to be easier in Kuwait than in many industrial and developing countries. This is due mainly to the existence of two alternative sources of finance for SMEs: government-subsidized lines of credit and capital, and Islamic financial products.

Subsidized credit and capital for SMEs

103. Most subsidized credit and capital for SMEs are channeled through the Industrial Bank of Kuwait (IBK).58 The IBK obtains long-term finance from the government59 at a negotiated rate and uses it to provide credit to medium and small companies (total investment valued ranging typically between KD 1 million and KD 7 million) at a fixed rate below the CBK rediscount rate.60 Loans could have a grace period of up to two years, and a maturity of up to six years thereafter. IBK may finance up to 50 or 65 percent of the total cost of the investment, depending on whether the project cost is up to KD 1 million or above. Financial conditions could be further improved if the project so deserves. Funding is available for start-ups, expansion of capacity, and a broad range of needs including financial restructuring. Collateral includes first mortgages on the project’s material and intangible assets. Other collateral may be required, depending on the case. As of end-2003, cumulative lending granted by IBK under its main industrial loans program reached KD 544.3 million, while the average loan amount was KD 0.8 million corresponding, on average, to 50.6 percent of the total investment.

104. There seems to be no rationing of IBK subsidized funds for SMEs. As of October 2004, the government revolving line was disbursed up to about 70 percent; that is, total outstanding credit to SMEs was about KD 140 million. According to IBK officers, they do not foresee major problems to obtain the necessary approval for additional funding in the event the SME demand for funds exceeds the current amount of the government line of credit.

105. In addition to the industrial loans program, IBK has two additional programs available for small enterprises and professionals. The program for small enterprises (handicraft and small enterprise financing portfolio) was established in 2000, and provides finance through Islamic instruments. Loans are substantially smaller than in the industrial loans program (average of KD 70,000 per operation), but represent a larger amount of the total investment by small enterprises (68.1 percent on average). The professionals program (portfolio for financing the professional activity and small projects) started in 1999. The IBK administers an endowment of KD 50 million, for 20 years, provided by the Industrial Investment Public Authority, to be invested in accordance with Islamic Sharia provisions. The program provides short-, medium-, and long-term financing for an amount ranging between 65 and 80 percent of the total investment (of no more than KD 500,000), under very favorable financial conditions (rate of return of 2.5 percent, and up to a 3-year grace period). Finally, IBK also contributes to the development of Agricultural SMEs with a specific loan program, and provides limited capital to industrial SMEs through its direct investments and promotion department.

106. In addition to the IBK, the Kuwait Small Projects Development Company (KSPDC), established in 1997, has an endowment of KD 100 million from the Kuwait Investment Authority (KIA) to help in the development of SMEs in Kuwait.61 KSPDC provides technical, legal and financial support to SMEs. KSPDC finances up to 100 percent of the establishment fees for SMEs start-ups, including due diligence, legal documents, and employment needs, plus up to 50 percent of the capital needed for the projects. KSPDC funds are in the form of venture capital and, therefore, no collateral is required.62 However, restrictions on management are imposed by contract, as well as a 5-year schedule for the repurchase of KSPDC shares at pre-agreed prices. In part, because KSPDC finance is relatively expensive (up to 74 percent accumulated financial cost over a 5-year period), it is considered to be the “last resource” for the SMEs unable to obtain financing through IBK or other channels. Up to end-2003, KSPDC had provided some KD 24 million in venture capital to 42 SMEs. An additional endowment of KD 100 million has been planned in the Kuwait National Technologies equity fund.

107. Access to finance by SMEs seems to be guaranteed within certain limitations. The major limitations of the subsidized finance channels to SMEs appear to be that financing: (i) is directed to certain economic sectors and types of projects, (ii) is restricted to Kuwaiti nationals; and (iii) must be provided to activities that are the full-time activity of the owner and/or CEO of the SMEs, thus making it incompatible with employment by the public sector. Other than these restrictions, there appear to be no major limitations for the SMEs to access subsidized financing in Kuwait.

108. Although Kuwait’s subsidized credit framework seems to overcome some of the traditional problems associated with credit ceilings, it has some drawbacks. Available information seems to confirm that traditional problems of subsidized interest rate lending schemes such as rationing are not present in Kuwait. However, ample availability of subsidized funds may be aggravating the problem of inefficient allocation of resources which also traditionally affects such schemes. The scheme also entails fiscal cost, although its magnitude does not seems to be significant.63

Islamic financing for SMEs

109. The Kuwait Finance House (KFH) provides a wide range of Islamic financial products for SMEs. KFH, established in 1977 and 49 percent state-owned, is the largest Islamic financial institution in Kuwait, and the second largest bank in the country with KD 2.3 billion deposits by end-2003, about 20 percent of total deposits. It provides a wide range of Islamic finance products for enterprises, including discount of effects, deferred sales, leasing, factoring, and venture capital. The KFH has a large base of over 500 SME customers, and has developed specific products for them, including cooperatives’ financing. Since KFH rates of return are not subject to lending rate ceilings, KFH is able to price products according to their risk and cost, reaching borrowers which are otherwise subject to the rationing imposed on commercial banks. KFH finance is particularly attractive to enterprises, vis-à-vis subsidized public finance, due to the larger percentage of financing provided in relation to the total investment needed (up to 100 percent).

110. In addition to KFH, a number of nonbank Islamic financial institutions and investment funds provide financial services for SMEs, some of them concentrating in the smaller companies. Also, a second Islamic bank (Bubyan Bank) was licensed in October, 2004, adding to the abundant supply of Islamic financial services for SMEs in Kuwait.

111. The drawback of Islamic financing to SMEs is an unleveled playing field with traditional commercial banks. Since yield of financial products for SMEs in Islamic institutions is not subject to the interest rate ceilings affecting commercial banks, there is a regulation-induced competitive disadvantage for the latter which may further affect the problem of inefficient allocation of financial resources mentioned in the previous subsections.

Obstacles to the development of SMEs in Kuwait

112. As discussed, lending rate ceilings affecting finance from commercial banks do not seem to be a major obstacle for Kuwaiti SMEs’ access to financing in sufficient quantity from government-subsidized sources and Islamic financial institutions. Therefore, the reason for the unsatisfactory development of the private sector and, in particular, the SMEs in Kuwait, lies mainly in nonfinancial obstacles.

113. A survey by the Kuwait University and the World Bank identified the dominant role of the public sector as the main obstacle to SME development. As reported by Webster (2002), the main problems in the business environment explaining the difficulties found for SME development are: (i) government subsidies on selected products and services exclude the possibility for private sector competition in their production; (ii) an inordinate amount of business opportunities depend on government contracts; (iii) high salaries, better working conditions and social status, and full employment policy in the public sector discourage Kuwaiti nationals to undertake SME operations (iv) due mainly to the higher labor cost, Kuwaiti production costs are not competitive with largely liberalized imports; and (v) over-regulation further raises the cost of doing business.

E. Conclusions and Policy Recommendations

114. Kuwait has followed a gradual approach to the liberalization of the financial system in the 1990s. As assessed by the IMF and World bank (IMF, 2004), the CBK has established a comprehensive system for banking regulation and supervision that conforms in most respects to international standards. The strong regulatory and supervisory framework has contributed to maintaining financial stability during the liberalization of the system, unlike some developing countries in Asia and Latin America. Furthermore, careful oversight has succeeded in preventing further financial crisis after the Suq al-manakh stock market crisis of 1982.

115. While monetary and supervisory policies have been effective in achieving their objectives, their efficiency could be enhanced by the gradual removal of the few still-existing administrative instruments. Specifically, lending rate ceilings are likely to have a negative effect on financial development and the efficient allocation of financial resources. In this particular aspect, Kuwait seems to be lagging behind since most countries within the GCC and the MENA regions have already completed the liberalization of their interest rates. Despite the fact that Kuwait’s lending rate ceilings do not seem to be affecting the average borrower of commercial banks, they seem to be binding on personal loans and on a significant share of corporate customers, particularly on the SME sector.

116. The obstacles on commercial bank financing to SMEs introduced by the lending rate ceilings are deemed to be largely offset by the existence of abundant financing at subsidized rates provided through several public-sector sponsored channels, and by the active involvement of Islamic financial institutions in the financing of SMEs. Non-financial obstacles seem to be more relevant in explaining the sluggish growth of SMEs in Kuwait. This notwithstanding, the removal of the remaining ceilings may have a positive effect on the development of SMEs and provide additional flexibility to the product development and pricing practices of banks. Also, it will enhance the efficiency of the allocation of financial resources and contribute to the price discovery function of the market. If the authorities were to discontinue or substantially reduce their financial support to the SMEs, removal of the lending rate ceilings should be considered so as to not to impact negatively the availability of credit for the sector.


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Prepared by Fernando L. Delgado.

Consumer lending and other micro and retail credit may also be affected by lending rate ceilings, as analyzed below. However, the analysis of the availability of credit to these sectors falls beyond the scope of this paper.

The links between administrative restrictions and difficulties faced by the SMEs in accessing bank finance are well documented in Beck, Demirgunc-Kunt, and Maksimovic (2003, and 2005), and Beck, Demirgunc-Kunt, Laeven, and Levine (2004). Rajan and Zingales (1998) in their analysis of data for 41 industrial and developing countries, find that financial liberalization is more beneficial for the rise of new firms than for the growth of existing firms. For an analysis of lending rate ceilings on micro enterprises, see CGAP (2004).

The link between SME development, economic growth and job creation is well documented. See, for instance, Kirby, and Watson (2003).

McKinnon (1973) and Shaw (1973) laid the basis for the current literature on financial development and growth. Levine (1997, and 2004) and Wachtel (2001) provide comprehensive surveys of the main contributions.

Policis (2004) analyzes the effect of lending rate ceilings on credit availability and cost in the U.S.A., the U.K., France, and Germany. The paper finds that the primary effect of the ceilings is to restrict product diversity and, when regulations do not allow lenders to accommodate ceilings with product innovation, to created credit exclusion. Also, when regulations are so stringent that they cannot be accommodated by either product innovation or non-bank lenders, they create the conditions for illegal lending, such as in France and Germany.

As mentioned in Alexander, Baliño, and Enoch (1995), interest rate ceilings may present some advantages in cases where entry barriers prevent competitive pricing of financial intermediation, where adverse selection is present (for instance, when information on borrowers is scarce or banking supervision is weak), or when market conditions prevent the authorities from achieving monetary policy goals through indirect instruments. Disadvantages of interest rate ceilings vis-à-vis indirect monetary policy instruments include distortions in the allocation of financial resources, administrative rationing of credit, and financial disintermediation.

Maximum marginal intermediation spreads are defined as the difference between the maximum lending rates (ceilings) and the marginal cost of funds for banks (discount rate or equivalent).

For a brief description of the policy evolution in Kuwait in the 1970s, 1980s, and the first-half of the 1990s, see Chalk, El-Erian, Fennell, Kireyev, and Wilson (1997).

The effective rate of consumer loans is marginally higher than the discount rate, since banks charge the interest on the loan principal upfront.

IMF (2004), p. 5, 6, 17, and 18.

In addition to capital-linked risk concentration ratios, consumer lending is restricted to 10 percent of customer deposits; the principal amount of personal or installment loans available to Kuwaiti individuals has a ceiling of KD 70,000; consumer loans cannot exceed the lesser of KD 10,000 or 10 times the monthly salary of the borrower; and total repayment burden of individual borrowers cannot exceed 50 percent of the borrower’s monthly salary. Total aggregate consumer and installment loans extended by a bank may not exceed a certain multiple of some funding sources (12 percent of total private sector deposits plus 30 percent of bonds issued and interbank loans received with a one-year maturity or longer).

The liquidity requirement varies according to the maturity of the bank’s liabilities, with an aggregated minimum liquidity requirement, to be invested in Treasury bills and bonds, of 20 percent of private sector KD deposits.

Except for a slight decrease in 1998, related to a severe correction in stock prices, the return on equity and the return on assets of Kuwaiti banks has increased steadily since 1995 to reach 20.4 percent and 2.3 percent, respectively, by September 2004. However, it is not possible to ascertain whether banks’ profits (if not profitability ratios) could have been even larger without these restrictions.

The risk of a particular operation will depend on the customer and the type of operation, including its maturity, collateral, and other characteristics.

Assuming that the rate differentials within the yield curve price maturity mismatch risk.

This is the case, for instance, in countries where interest rates were controlled for a long time. In many cases, the interest income implicit in the mandatory interest rate ceilings and floors ensured the average bank profitability without the need to charge fees for most of its lending and deposit-related services. Long after interest rates were liberalized, customers still are inclined to reject paying for certain bank services, a factor which often leads banks to cross-subsidize these services by increasing the price in associated products or services.

This provides partial relief for the differences in operating costs and risk associated to different products, but it fails to ensure the flexibility to accommodate differences in the elements affecting pricing within each type of product.

If Kuwait’s financial market was efficient and liberalized, the cost of funds relevant for all operations of the same maturity would be identical, as discussed above. Since the confluence of the lending rate ceilings with the newly introduced ceiling on the net lending to the private sector to total deposits ratio has resulted in a segmentation of the market, this is no longer the case. For instance, since July 2004 the cost of funding for interbank loans is substantially lower than the cost for non-financial private sector loans. As a result, the ceiling may not be binding for interbank loans and still be binding for non-financial private sector operations.

However, the average deposit rate does not include the operating expenses linked to the deposit activity of the banks and, therefore, the difference between the average and the marginal cost of funds would be somewhat lower.

There is little information on the interest rates effectively applied by size of the borrowing company. This estimate is based on the historical series of financial costs by size of company compiled by the Bank of Spain (2004), based on a sample of 8,000 Spanish companies. However, the under-representation of small (and micro) companies in the sample may result in underestimating the premium on SME financing, since, in principle, a correlation may be expected between size of the firm and risk premium.

The data for Chile corresponds to the Superintendency of Banks and Financial Institutions of Chile in 2000, the data for El Salvador and Chile was estimated by Grupo DFC (2002), p. 32. The spreads are substantially higher for the very small companies (micro enterprises), ranging from 3 to 50 percentage points in a sample of 6 Asian countries (CGAP, 2004, p.4).

This is reflected in the wide range of lending rates applied to SME. These ranged between 14 and 21 percent in El Salvador, and 24 to 30 percent in Peru, According to Grupo DFC (2002), pp. 51 and 65.

This could be interpreted as a prudential strength, since higher risk customers and operations are thus excluded from the formal market. However, dealing with high risk customers is possible with adequate risk assessment and management systems, together with flexible pricing policies, as demonstrated by hundreds of banks around the world. Furthermore, precluding some of these high risk customers from receiving bank finance, such as SME start-ups, may have a negative impact on the development of the private sector.

Data on the percentage of loans granted at the maximum lending rates in each one of the five lending ceilings’ categories, and the average lending rate per category, might have offered further insight.

Since all consumer loans are granted at the maximum lending rate, there is little doubt that the ceiling is binding for this type of product. Furthermore, since CBK’s discount rate is effectively the marginal cost of funds for Kuwaiti banks, in the margin, the ceiling on consumer loans (which is set equal to the discount rate) will not allow banks to cover operating costs and risks associated with consumer lending on the margin. In practice, consumer lending may be profitable for some banks because of the large amount of low-cost deposits (as of end-December 2004, 22 percent of total deposits were unremunerated, and 25 percent had interest rates below 2 percent) and the special collateral regulations that allow banks to deduct payment for consumer loans directly from the borrower’s payroll. This may explain why consumer loans represented about 7.5 percent of total nongovernment credit as of end-September 2004, despite the quantitative ceilings imposed on this type of product.

These include consumer loans, installment loans, loans for the purchase of securities, and other personal loans.

The segmentation in the Kuwaiti financial market appears because the ceiling in the credit to loan ratio has made non-fungible the alternative funding sources for banks. Thus, a bank may be very liquid but, if its ratio of net loans to total deposits is close or above the ceiling, it may have to compete by raising customer deposit interest rates to maintain or by expanding its credit to the private sector. At the same time, since other profitable alternatives for placing its excess liquidity in KD are very limited, the banks are willing to lend it to other banks in the interbank market at very low rates. Therefore, the interbank and customer deposit rates become disconnected, leading to market segmentation.

From June to October, 2004, weighted average interest rates for 1-year term deposits of over KD 1 million increased by 1.4 percentage points, to 4.72 percent. Marginal rates for 6-month and 1-year term deposits of over KD 1 million in October 2004 were of 5.04 percent and 5.13 percent, respectively.

The IBK was established in 1973 as a joint venture between several government agencies and the private sector, with majority control by the former.

A revolving facility for KD 200 million has been extended to IBK through KIA. Funds are remunerated at KIBOR if on lent to final borrowers, and a 0.5 percent fee is applied to disbursed funds not yet on lent.

Rates were reduced to 3.5 percent in November, 2003.

Qualifying SMEs could operate in any economic sector but real estate, financial brokerage, agriculture and agro-industry, and public transportation. Also, the size of the investment could not be more than KD 500,000 and not less than KD 50,000.

Alternatively, KSPDC may participate in projects with third-party financing. In this case, it could finance up to one third of the total investment and collateral is required.

A rough estimate of the fiscal cost of the main IBK line during 2004 would reach some KD 3.5 million (about 0.02 percent of GDP), although it does not include the cost of write-offs (which is traditionally large in this type of programs) as there is no available information.

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