The financial system serves as an intermediary between borrowers and lenders or, from the economic perspective, between the saving and investing activities in an economy. The smooth functioning of this system is an important attribute of economies and assures the flow of financial resources from where they are generated to where they are needed and used efficiently. Impediments or breakdowns in the system, accordingly, will pose problems for overall economic well-being. Thus, the oversight, regulation and, where necessary, the reinforcement provided to financial institutions by the authorities are important safeguards to the system.

The financial system serves as an intermediary between borrowers and lenders or, from the economic perspective, between the saving and investing activities in an economy. The smooth functioning of this system is an important attribute of economies and assures the flow of financial resources from where they are generated to where they are needed and used efficiently. Impediments or breakdowns in the system, accordingly, will pose problems for overall economic well-being. Thus, the oversight, regulation and, where necessary, the reinforcement provided to financial institutions by the authorities are important safeguards to the system.

The experience of Kuwait over the past few decades illustrates both significant progress and instances of problems in the management of financial structure in this small, open economy. Endowed with a variety of banks and other intermediaries, and well-connected to the international financial markets, Kuwait has moved toward liberalization of its monetary policy and financial system, at the same time working to overcome the effects of major crises on financial stability. This section provides an overview of these developments. It reviews the structure and experience of Kuwait’s financial system over the past 20 years to document the evolution in policy and the response of policymakers to the challenges posed by these crises.1 Specifically, it provides an overview of Kuwait’s financial structure, and discusses policy evolution and tools used following the Souk Al-Manakh crisis, advances in supervision and regulation, and monetary developments into the mid-1990s.

Overview of Kuwait’s Financial Structure

Kuwait has a relatively diversified financial system (Table 5.1), the structure of which has not changed markedly for several decades. The main institutions include—in addition to the central bank— seven commercial banks, two specialized banks (the Industrial Bank and the Real Estate Bank), the Kuwait Finance House (KFH), which operates on Islamic principles, about 24 investment companies and a similar number of insurance and reinsurance companies,2 a number of money changers and exchange houses, and the Kuwait Stock Exchange. Of the two specialized banks, the Industrial Bank concentrates on medium-term industrial credits, and the Real Estate Bank makes housing and property loans. A third “specialized bank” of the 1980s, the Credit and Savings Bank, was principally funded by the government and now is being merged with the Public Housing Authority.

Table 5.1.

Structure of Financial System

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Sources: Central Bank of Kuwait; and Kuwait Stock Exchange, Investor’s Guide, 1994.

Branch of Bank of Bahrain and Kuwait, not listed.

Islamic bank, not under the formal supervision of the central bank.

Among these institutions there is a familiar division of activities and specializations. Most deposit-taking and banking activities are carried out by the commercial banks, the KFH, and to a minor extent by some of the investment companies. Although instruments and techniques have changed, the range of commercial bank operations has remained much the same during the past 20 years. Activities of the investment companies have broadened somewhat. In the 1970s and early 1980s, the investment companies focused mainly on placing and managing funds (usually in foreign markets) for domestic customers. More recently they have diversified into such activities as taking positions as principals and underwriting securities. As noted, some of them accept “deposits” in a manner similar to banks. The money changers and exchange houses in Kuwait are restricted to exchange and remittance activities, that is, largely to buying and selling foreign exchange and are not permitted to take large open positions or engage in lending activities.

The Kuwait Stock Exchange, which has existed since the early 1970s, trades mostly local stocks (about 50 companies were listed as of mid-1996); bonds are also traded on the market, but in much lower volume. Activity on the Stock Exchange has expanded—especially in the last two years, as large shareholdings of the government have been sold—but likely remains below potential because of prohibitions on transactions by nonresidents of GCC countries.3 A parallel, informal stock market, the Souk Al-Manakh, flourished from the mid-1970s until 1982, when it collapsed. The repercussions from this episode—discussed in greater detail in the next section—continue albeit to a declining extent.

Another enduring feature of the Kuwaiti financial structure is government ownership and control, at least in part. All except one of the commercial banks are partly owned by the government, which has majority holdings in Burgan Bank and the Bank for Kuwait and the Middle East, and minority holdings in four other banks and the Real Estate Bank.4 Among the other institutions, the Credit and Savings Bank is also wholly public; KFH is two-thirds, and the Industrial Bank is 50 percent, government owned. Similarly, the government has significant shareholdings in some of the investment companies, such as the Kuwait Foreign Trading, Contracting and Investment, the Kuwait International Investment Company, and the Kuwait Investment Company.

Not all of the public ownership came about by de-sign. Many of the shareholdings were acquired in the turbulent wake of the 1982 collapse of the Souk Al-Manakh, when the government for several years maintained a policy of propping up both share prices and companies listed on the Stock Exchange to contain the effects of that crisis. A process of divestiture began in the early 1990s with the KIA selling some of its shareholdings.

The relatively diversified structure described here has been typical in Kuwait for more than two decades. Indeed, when the central bank was established in 1968—replacing the currency board that had been operating since independence in 1961—it was given a broad range of central banking powers because of the diversity and maturity of the existing system. At the time, there was hesitance about establishing a wholly independent central bank, and for a number of years the central bank shared authority with the Ministry of Finance, for example, in its ability to set interest rates. By the mid-1970s, how-ever, these restraints began to loosen, and in 1976 and 1977 amendments to the central bank law empowered the central bank to set interest rate ceilings without approval from the Ministry of Finance. The law also expanded the central bank’s powers to regulate banks and other financial institutions, to issue, discount, and trade in negotiable instruments, to set and adjust capital requirements for financial intermediaries, and to extend emergency credit to these institutions when needed. Thus, as long as almost 20 years ago, the central bank was granted a measure of independence and entrusted with a wide array of the necessary central banking tools. In an overview that focuses on the evolution in Kuwaiti financial structure, this early maturation of the central bank is a step that must be noted and mentioned. In most of the. subsequent liberalization and changes, including coping with financial crises, the central bank has been a principal actor.

Significant financial deepening in Kuwait took place in the 1970s, associated to a large extent with the surge of petroleum income. Changes were rapid, with the estimated ratio of financial assets to GDP in Kuwait climbing from 44 percent in 1974 to 116 percent in 1980. By the end of the 1970s, the central bank also had acquired a wider range of powers, commensurate with a more sophisticated and diverse financial system. At the time, however, interest rate and liquidity management policy were not very active. The Souk Al-Manakh collapse in November 1982 and the disruptions caused by the August 1990 Iraqi invasion have put the financial system to a test, which the central bank has successfully faced in recent years.

Policy Evolution in the 1980s

Although the preservation of institutional integrity was a dominant theme in the 1980s, the Kuwaiti authorities also made significant progress in developing and using the central bank’s policy tools. As noted earlier, the central bank’s powers and array of potential tools had already been expanded in the mid-1970s by amendments to the central bank law. The use of a number of these tools was changed during the 1980s which, in general, involved greater flexibility. Financial controls by the central bank were liberalized in stages into the 1990s, even as it acquired a higher level of independence from the government. The basic monetary policy tools employed in Kuwait are first discussed, followed by brief accounts of the central bank’s evolving interest rate policy and techniques of liquidity management. Table 5.2 provides a synoptic view of these tools and techniques.

Table 5.2.

Evolution of Monetary Policy instruments

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Sources: Central Bank of Kuwait; and IMF staff estimates.

Monetary Policy

Among its basic monetary policy instruments, the central bank has employed reserve requirements continuously over the period under review. Such requirements have been in effect since 1980; commercial banks are required to maintain 3 percent of their deposits in vault cash, central bank balances, or government (previously central bank) bills. The same requirements apply to the specialized banks. The KFH, technically, is not subject to this rule, but it complies for the most part with central bank directives. It may be noted that reserve requirements have not changed since this tool was introduced.

The central bank’s policy of maintaining un-changed reserve ratios has been similar to that in the major industrial countries, where the active use of reserve requirements also has declined in recent years. The very open nature of the economy, together with capital flows that are responsive to exchange market conditions, suggested to the authorities that an interest rate policy was the appropriate primary tool to affect monetary conditions in support of a stable exchange rate.

Interest Rate Policy

Given the openness of the economy and the exchange rate anchor, the Kuwaiti authorities have traditionally tried to meet their objectives by controlling or influencing interest rates. The history of the 1980s and 1990s shows a gradual series of steps toward more flexible use of this instrument. The authorities have moved away from direct controls, to almost complete reliance on market forces and indirect influences exerted by the Central Bank. Some of the principal stages in this evolution follow:

• During the late 1970s the authorities relied extensively on direct controls on both bank lending and deposit rates. For example, a maximum (effective) rate of 10 percent applied to loans over a year in maturity. Rates, also mandated, for shorter loans were lower and depended on collateral, and whether the loan was regarded as “productive” or not.

• Minimum rates also applied to bank savings deposits. The central bank’s power to set rates during this period was subject, in general, to concurrence by the Ministry of Finance. Lower oil revenues during the first half of the 1980s tended to put the rigid interest rate structure under stress.

• In March 1987 a new structure was introduced. Various limits were adjusted, and rates on loans over one year were linked to the interbank market rather than being set in absolute terms as before.

• In December 1988 the whole interest rate structure was linked to the discount rate—for example, a 2 percent margin for loans of less than one year and 2.5 percent for those greater than a year in maturity. Minimum rates on time deposits were likewise set with respect to the discount rate. Indeed, the margin for time deposits of less than three months was set at zero, and that for time deposits of greater than six months was only 1 percent above the discount rate.

• Apart from the already extant minimum rate on passbook savings, the 1988 policy revision marked the first time that the central bank mandated a minimum rate on private deposits denominated in dinars. The discount rate became the pivot for the Kuwaiti interest rate structure with the December 1988 changes. In response to higher international rates at the time, the central bank raised the discount rate to 7.5 percent (from 5.0 percent), which shifted the prevailing level of domestic rates noticeably upward. While this initiative linked the whole structure to a central element that could be tuned to international conditions, in practice the central bank did not change the discount rate again until April 1993. In effect, the post-1988 interest-rate regime combined a fixed spread with a ceiling on loan rates, a system that had its own problems and rigidities, and one that was changed after the 1990-91 crisis.

• The latest steps in interest rate reform, to date, took place during 1993-95. Adjustments to changing conditions became more frequent and the advantages of wider financial liberalization became more persuasive to the authorities. Between November 1993 and August 1994, the central bank adjusted minimum rates on savings accounts several times, and in 1994 increased the discount rate on three occasions, in response to international rate movements and to foster exchange rate stability of the dinar. Finally, in February 1995 the authorities deregulated interest rates on all deposit accounts, and they also removed limits on banks’ fees and charges.

• At present, therefore, rates payable on liabilities of financial institutions are effectively decontrolled in Kuwait, so that domestic financial market conditions are more openly linked to international developments than in the past. The only controls remaining are those on certain lending rates, which continue to be linked to the discount rate. There is discussion about whether these remaining controls should also be relaxed.

Liquidity Issues and Management

Liquidity issues in the domestic market have two dimensions: those that affect an individual bank, and those that are market wide. In Kuwait, bank-specific liquidity has been enforced through minimum liquidity ratios. These have been in effect since 1974, or even longer than reserve requirements.5 Banks are required to hold “liquid” assets, which generally have been defined as cash, balances with the central bank, and holdings of bills and other liquid assets (and, sometimes, local shares). While, during part of the 1980s, the liquidity ratio was 25 percent of total deposits and other liabilities, the requirement has become more nuanced over time according to the liquidity of the underlying liabilities. In 1995, for instance, it ranged downward from 35 percent on demand deposits to 20 percent on time deposits of three-six months maturity, and to 5 percent on time deposits of more than a year in maturity. This evolution of minimum ratios is one indication of adaptation in central bank policy, but it has not been the primary instrument of policy change; liquidity ratios are more in the nature of precautionary balances than tools of macro policy. As with reserves, it is clear that the central bank has not aggressively used liquidity requirements as a principal tool of its monetary objectives in recent years.

An area in which central bank policy tools have actively evolved has been liquidity management in the broader framework of macro policy. In this context, liquidity management can be understood as the indirect means of influencing interest rates, as opposed to setting them by regulation. As in most other countries, liquidity management in Kuwait has been defined by the types and modalities of central bank purchases and sales (including swaps) of market instruments with the banking system. In some cases, too, it encompasses the central bank’s policy about direct lending to these institutions.6 In general, how-ever, “liquidity management” has been an important and durable theme in the central bank’s operations during the 1980s and first half of the 1990s. This is largely because exchange rate stability has been a prevailing objective for the central bank over this entire period. The Kuwaiti economy is so open that significant deviations of domestic from international interest rates can always induce capital flows of considerable magnitude. These, in turn, in given circumstances, force intervention in the exchange market by the central authorities if they propose to defend their chosen external value for the currency.7

Table 5.3 shows selected data on the use by the central bank of its policy tools for liquidity management purposes, illustrating the quantitative aspects of instruments employed during the past 15 years.8 The profiles of these instruments, on balance, is consistent with the trends toward “liberalization” discussed above.

Table 5.3.

Selected Monetary Policy Tools

(In millions of Kuwaiti dinars)

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Sources: Central Bank of Kuwait, Quarterly Statistical Bulletin; and National Bank of Kuwait, “Banking and Monetary Policy in Kuwait,” NBK Economic and Financial Quarterly, No. 3 (1995), pp. 30-39.

As Table 5.3 shows, the central bank has employed discount operations (on commercial paper) over most of the period under review. In fact, discounting constituted the principal share in liquidity operations until about 1985, and until early 1987 the rate on discount borrowing (that is, the discount rate) varied in line with the maturity of the discounted paper. Beginning in March 1987 the discount rate was set at a single level (that is, 5.5 percent) for all maturities of paper, and it has been adjusted periodically in the years since. Terms and conditions of borrowing were changed on various occasions between 1989 and the closing of the discount window in August 1995. Most commonly, the central bank has maintained time limits on the tenor of discount loans,9 and it has frequently had “unannounced limits” on the amounts that one institution could borrow at this window. Technical assistance advisors to the central bank in 1989 made a number of recommendations to reform the discount window, in part to ad-dress the concern that the level of the discount rate was providing concessional financing to some sectors of the economy. As Table 5.3 suggests, the high water mark of discount operations was reached in the mid-1980s. Both the substitution and greater flexibility of other instruments contributed to the subsequent decline of this form of operations.

Table 5.3 also illustrates that the central bank lent against banks’ holdings of central bank bills for a number of years. These bills were attractive to the banks, partly because they contributed to satisfying the reserve and liquidity requirements. They had, in general, maturities of 7 to 91 days and therefore turned over rapidly. Central bank bills were phased out in 1987 when the government began to issue treasury bills and bonds as part of its general financing and in connection with the costs of cleaning up the Souk Al-Manakh problems. Indeed, the stock of public debt instruments has risen about fivefold since the bills and bonds first came on the market. Government public debt instruments are discussed below.

Foreign exchange swaps as a liquidity device are also shown in Table 5.3. Swaps had variable maturities, to a maximum of six months, and the year-to-year amounts were also quite variable, depending on international interest rates and the central bank’s sense of incipient capital flows. The use of foreign exchange swaps declined to negligible amounts after the mid-1980s, but was revived again for a time in 1990-91 during the immediate restoration of the financial system after Kuwait’s liberation from occupation. They were phased out again in 1992.

Enforced “bank deposits” with the central bank were in use for about five years in the 1980s, reaching substantial amounts (KD 570 million) in 1986. Intended to absorb “excess liquidity,” these deposit levies were analogous to an increase in reserve requirements; they were discarded after the 1988 reforms that brought domestic interest rates into better alignment with international rates. As noted earlier, the motivation for central bank loans to, and low cost deposits with, the commercial banks from the mid-1980s onward was less to increase bank liquidity than to ensure the banks’ viability through a form of implicit recapitalization during the workout from the Souk Al-Manakh difficulties. These deposits have receded to low levels, partly because of the exchange with “debt bonds” that were issued in 1992 as part of the next round of efforts to settle the debt problems from the 1980s and the 1990-91 occupation (see Section VI).

The authorities have allowed most of the instruments shown in Table 5.3 and used during the 1980s to fall into disuse. This is in part a reflection of the increased flexibility and liberalization that was approached late in the decade, and which has been reached more fully only in the mid-1990s. The “provision” and “absorption” of liquidity by the central bank became less necessary as reforms of interest rate controls and growth of the interbank market helped the Kuwaiti financial system respond more flexibly to domestic and international influences.

Liquidity management remains an objective for the central bank, as for most central banks. In recent years this has been increasingly attained through transactions in government debt securities, which are held by both the central bank and other institutions. These “bills and bonds”10 were first brought to market in November 1987, subject to a KD 1.4 billion global ceiling on government debt. By the end of 1989 the ceiling had been increased to KD 4.1 billion, and then to KD 10 billion in 1991. Kuwait’s debt ceiling remains at that same level at present, although the stock of outstanding domestic debt (apart from the DCP “debt bonds”) hovers near the limit. Both the net issuance of government debt instruments and central bank decisions about “open market” purchases and sales can be used to fine-tune bank liquidity, insofar as this objective still is pursued in the current environment. The central bank’s greater reliance on open-market style operations (including repos and reverse repos, which are the domestic currency counterparts to foreign exchange swaps) accomplishes the same ends as its earlier use of a wider and more cumbersome set of instruments. A further aspect, of course, is that the central bank no longer issues its own instruments to the market; the emphasis is on a set of instruments issued by the government itself that backstops the central bank’s fine-tuning efforts.

The principal monetary policy tools used over the years by the central bank were summarized in Table 5.2. Further comments on those used most recently appear in the concluding section.

Developments in Supervision and Regulation

In the aftermath of crisis and loss, progress is often made in the supervision of national financial institutions and usually a stronger and more resilient system results. The difficult art of supervision consists in deciding on—and enforcing—a set of rules that ensures the safety and soundness of financial intermediaries and their creditors, while at the same time not suppressing their ability to seek profits by taking risks and lending in support of productive and profitable economic activities. Table 5.4 gives an overview of key elements of bank supervision developed in Kuwait.

Table 5.4.

Key Elements of Banking Supervision

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Source: Central Bank of Kuwait.

In Kuwait the shock transmitted by the Souk Al-Manakh collapse gave sudden impetus to improvements in the oversight of institutions by the central bank. Even earlier, however, some steps had been taken, as in 1975, when a “Center of Risks” was established to evaluate credit applicants, or in 1980, when the central bank gradually reduced the amounts that banks could extend in overdrafts—at that time one of the principal forms of extending credit to customers. Following the Souk Al-Manakh crisis—an asset price bubble that was characterized by massive amounts of postdated checks—one of the initial steps of the authorities was to forbid the discounting of postdated checks or taking them as collateral for loans.

In the next few years, further measures were put in place to strengthen the regulatory environment. Both the development and implementation of these measures likely were encouraged by parallel international developments during the 1980s, such as progress in international monitoring of banks and the risk-weighted capital adequacy standards associated with the Basle Committee. By mid-decade, the central bank had, for instance, taken the following steps:

• Established a national debtor reporting system as part of the effort to clean up after the Souk Al-Manakh crisis.

• Instituted quarterly reporting by banks and non-banks on the quality of their loan portfolios.

• Required submission of monthly balance sheets to the Supervision Department of the central bank.

• Prohibited the extension of credit exceeding 10 percent of a bank’s own funds to any one entity.

• Acquired jurisdiction11 over money changers and foreign exchange dealers, who were required to register and file supervisory reports with the central bank by March 1986, and who were further prohibited from conducting banking business.

• Introduced provisioning requirements for spot and forward foreign exchange positions.

A formal provisioning system for loans held by the banks was imposed by a December 1985 decree. Under this system, all loans require general provisions of 3-5 percent of the face amount, and loans are classified as “regular” or “irregular.” Irregular loans are subdivided into several grades, ranging from “substandard” to “bad,” and provisions on these range upward from 15 percent, depending on how long payments have been delinquent, starting with 180 days. A “bad” loan, for instance, is more than a year in arrears, and the required provision is 100 percent of the balance.

Other advances in supervision and regulation have been largely in line with recommendations of the Basle Committee. Apart from the most recent developments (see Monetary and Credit Developments below), between the mid-1980s and early 1990s the central bank established consolidated monitoring of Kuwaiti banks and their foreign affiliates, and strengthened surveillance of banks’ portfolio exposure by economic sector, to individual customers, and in foreign exchange operations. By the end of 1992, banks were also obliged to prepare their financial statements in accordance with international accounting standards, and the central bank had required the banks to meet the risk-weighted capital adequacy standards of the Bank for International Settlements with a mandatory ratio of 8 percent.12

In 1994-95 the central bank continued strengthening its supervision in compliance with the Basle Committee recommendations, and in the areas of on-and off-site examinations, auditing procedures, rules concerning insider loans, and foreign exchange exposure of the banks. For example, an amendment to the credit concentration rules was approved in April 1995, increasing the exposure limit to a single borrower from 10 percent to 15 percent of capital. Lending in excess of 15 percent (as defined by the Basle Committee) may only be permitted if the customer provides collateral (cash or treasury bills). Total bank credit exposures of more than 10 percent must not exceed 400 percent of capital. In November 1995 new regulations were issued on extending credits by local banks to the members of their board of directors. Such credits now require three quarters’ majority approval of the bank’s board. Interest and commissions should be in conformity with the rates for all customers, and no other preferential treatment is permitted. In April 1995, the central bank also deregulated (that is, effectively canceled all previous regulations) fees and charges that local banks may charge. Finally, in September 1995 it drafted regulations for the study by local audit companies of the adequacy of the internal control systems of local banks. The exercise was due to be carried out in July 1996 covering the year ended June 30, 1996. Reports will be on an annual basis.

The central bank has also made commendable advances in prudent monitoring and supervision of Kuwait’s banks, investment companies, and exchange houses. It has intervened forcefully in at least one respect—rules concerning personal loans. This development is discussed in the next section.

Monetary and Credit Developments

Considering the stresses placed on the financial system over long periods after the 1982 Souk Al-Manakh crisis and, later, by the 1990-91 regional crisis, the recovery of the system and its adaptation to more liberal rules have been a noteworthy accomplishment. Taking all these factors into account, monetary trends during the years of crisis and reform, including the most recent interval, were surprisingly moderate. By way of review, Tables 5.5 and5.6 show the factors that affected liquidity during 1992-95 and, for comparison, of longer intervals from 1981 to 1995, respectively.

Table 5.5.

Factors Affecting Changes in Domestic Liquidity, 1992-March 1996

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Source: Central Bank of Kuwait.

Treasury bills and bonds.

Table 5.6.

Factors Affecting Changes in Domestic Liquidity, 1981-95

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Source: Central Bank of Kuwait.

Turning first to the most recent trends, broad money growth generally was moderate in the early 1990s, reflecting mainly the growth in net domestic assets. In 1995, however, liquidity surged to 9.4 percent, resulting from a 3.3 percent increase in net foreign assets and a 6.1 percent increase in net domestic assets. The domestic component represented strong claims on nongovernment sectors—almost 13 percent—which were much higher than normal. This buoyant rise in private claims echoes in part a more optimistic business outlook—including favorable response to the KIA’s divestiture of company shares. In addition, it is believed that some foreign assets were repatriated and loans extended to share buyers and to assist debtors with the first installment under the Debt Collection Program.

Taking a longer view, for the 1980s as a whole (see Table 5.6) broad money grew at an annual rate of 7.5 percent. This growth was likewise driven principally by an expansion of net domestic assets, and most of this, averaging 8.5 percent a year, also rose from claims on nongovernment sectors. Data for the 1981-85 and 1986-89 subperiods, however, are quite different, but intuitively consistent with the events that defined these intervals. For example, broad money growth in the first half of the 1980s was relatively high at 10.0 percent, driven by an annual growth of 13.5 percent in nongovernment claims. Considering the amount and rapidity of debt growth associated with the Souk Al-Manakh early in this period, such a result is not surprising.13 For 1986-89, however, the growth rate of broad money drops by more than one half, and the composition of liquidity changes noticeably. In part owing to less favorable oil market conditions, and in part owing to policy changes such as the issuance of government debt, net foreign assets declined and claims on government accelerated to a 5.1 percent annual rate in the second half of the decade. As might be expected, the growth rate in private sector claims falls to rather low levels during this consolidation phase of bailout and reform.

Two aspects of these liquidity changes might be noted. First, despite the financial turbulence of this period, monetary growth in Kuwait remained within reasonable bounds throughout the 1980s. The cautious liquidity policies and heightened supervision exercised by the central bank contributed to this favorable result. As has been noted elsewhere, the Kuwaiti economy is so open that the money supply may be largely the result of demand-side influences. The “natural course” of liquidity in Kuwait may lie within certain moderate limits.

Second, monetary developments in the second half of the 1980s were quite similar to the growth pattern shown in Table 5.5 (see also Figure 5.1) for the 1992-95 period, once Kuwait had recovered from the dislocations of the 1990-91 occupation. That is, annual broad money growth of about 5 percent arises mainly in net domestic assets, with net foreign assets of the banking system a roughly neutral influence.14 This apparent stability in Kuwaiti money demand is supported by several important factors. One is the relatively slow and steady course of domestic non-oil prices and activity. A second is openness; capital flows smoothly into and out of Kuwait, and domestic balances are not much distorted by controls or surprises. Still another factor is the ability of the authorities to maintain a stable exchange regime.15

Figure 5.1.
Figure 5.1.

Contributions to Liquidity Growth

(Subperiod averages, 1981–95; in percent of total)

Note: Net contributions sum to percent of total broad money growth.Sources: Kuwaiti authorities; and IMF staff estimates.

To conclude this brief review of monetary trends, data from early 1996 suggest that the unusually strong growth of 1995 may have ended. Liquidity expanded at only 0.5 percent (about 2 percent at an annual rate) during January-March 1996. One factor in this slowdown has been the central bank’s partial return to direct controls, notably the additional restraint applied to personal lending. These loans have been placed under more direct control through credit ceilings under the November 1995 and April 1996 amendments to the 1993 regulation on consumer and installment loans. These changes tightened the rules about extending credit to individuals, and the amounts of these loans have contracted. According to current regulations, the following now apply:

• Aggregate consumer and installment loans cannot exceed 10 percent of a bank’s total private deposits.

• The amount of a personal loan cannot exceed ten times the customer’s monthly salary or the maximum of KD 10,000, whichever is less, and the amount extended to a single customer cannot exceed KD 70,000.

• The total of monthly repayments for any one customer on one or more loans cannot exceed 50 percent of monthly salary. The maximum limit on the loan repayment period was reduced from three years to two years.

The central bank appears to have resorted to direct controls on personal loans because—and pending further programs in the DCP—demand seems to be rather inelastic; the effective interest rate on personal loans is about 14 percent. More generally, as trends in personal lending suggest, liquidity is perceived to be high. Because the stock of treasury bills and bonds approached its legal ceiling in December 1995, the central bank expanded its usual forms of liquidity management with a new strategy, the socalled liquidity scheme. When the statutory ceiling on treasury bills and bonds issued is reached, the central bank opens a deposit window for local banks to place one-month deposits at a competitive interest rate. The central bank receives, at a sealed bid auction, offers from the local banks on the amounts and interest rates at which they are ready to deposit resources with the central bank, and deposits are taken accordingly. This scheme has been used to squeeze excess liquidity as needed. Additionally, in November 1995 the central bank closed the discount window and withdrew all its deposits from the local banks.

As to current interest rate trends, the central bank has left the discount rate unchanged since April 17, 1995, at 7.25 percent (see Table 5.7). Since the discount rate determines the levels of repurchase, overnight, and loan rates, these too have remained steady for more than a year. The differential between the dinar interbank and the U.S. dollar LIBOR rates narrowed in 1995, with the margin for three-month deposits averaging 1.39 percentage points, compared with 1.52 percentage points in 1994. By March 1996 the spread rose slightly, to 1.45 percentage points, but changes on this order are not significant. The average interest rate on dinar-denominated deposits for all maturities moved up in 1995. The rate ceiling on commercial loans (9.75 percent to 11.25 percent, depending on maturity) was still considerably higher than the current money market rate (about 7 percent) and was not binding.

Table 5.7.

Structure of Interest Rates on May 15, 1996

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Sources: Central Bank of Kuwait; and IMF staff estimates.

March 1996 average rates on three-month treasury bills and deposits in dinars.

Real rate of about 14 percent.


The basic structure and institutional features of Kuwait’s financial system have not changed much over the past 20 years. These two decades were, however, both eventful and stressful, largely because of the Souk Al-Manakh crisis in the early 1980s and the regional crisis of 1990-91. The years following the Souk Al-Manakh crisis were marked by efforts on the part of the Kuwaiti authorities, both to surmount the financial consequences of the huge debts left by this episode and, simultaneously, to widen and deepen the instruments of monetary policy employed by the central bank.

For the most part it can be said that the authorities succeeded in their goals, even if the debt overhang arising from the Souk Al-Manakh crisis lingered into the 1990s. The central bank made significant progress in developing its policy instruments during the 1980s by relying more on indirect means of monetary control, moving gradually toward a more flexible and liberal regime, establishing an independent role among Kuwaiti institutions, and by bolstering its supervisory functions across a broad front. The essential success of this effort is perhaps illustrated by the fact that, despite the stress, the structure of the system remained intact and most of Kuwait’s financial institutions emerged from the decade in better condition than they had enjoyed for years previously. While there is no doubt that Kuwait’s substantial resources played a role in these developments, the basic policy setting and policy directions also were appropriate to the challenges.

The setback of 1990-91 was severe, but by mid-decade it had been left substantially behind. In the years since liberation, the central bank has continued forward on much the same course it took in the 1980s, in both liberalization and strengthened prudential regulation and supervision until, by 1994, most of the objectives had been reached.

As to the near future, policies continue to be reviewed and further changes for strengthening the supervisory and regulatory regime are under consideration. In addition to actions by the central bank, local banks plan to establish by the end of 1996 an interbank center of risk assessment to assist in evaluating the financial positions of persons applying for credit. Indeed, considering the progress made in the past two decades in both the exercise of monetary policy instruments by the authorities and the restoration of reasonable health to the financial infrastructure, current indications are that this progress will continue in the future.


Debt workout issues are considered in greater detail in Section VI.


Most of the insurance companies are local agencies of foreign operations, but some are national.


Consideration is being given to lifting these restrictions, as discussed later.


Government ownership in Kuwaiti banks and other institutions is exercised through the Kuwait Investment Agency (KIA).


As is evident, the use of liquidity ratios is in the nature of prudential regulation, to ensure that individual banks preserve a balance sheet structure that is robust against unexpected shocks.


The many possible distinctions cannot be surveyed here. “Discounts,” “swaps,” “lending” (for example, against collateral), and “repurchases” are all variants of a single, central theme, that is, the amounts, rates, and time interval of resources that the authorities are prepared to provide (or absorb) to (or from) the financial system in a given set of circumstances. The bottom line effect of all such operations is to influence domestic interest rates.


It should be clear that downward pressure on a currency can be resisted more easily the higher the level of foreign reserves to support the intervention.


The purpose of this section is to illustrate the range of instruments that the central bank has used, rather than to examine the actions taken in specific circumstances in recent years.


The bookkeeping conventions for discounts, repurchase agreements, and similar operations can vary widely. In some cases operations are treated as outright purchases and sales on banks (and central bank) balance sheets; in others the entries may appear as collateralized lending.


Originally issued only in maturities of 90 days, bills are for less than a year and are issued at discount; bonds have maturities of one to ten years and are issued at face value with a fixed rate.


By a ministerial decree of March 1984.


As noted by some observers, the fact that their portfolios were dominated at the time by debt settlement bonds helped all Kuwaiti banks “comfortably” meet this requirement.


The initial growth of private debt surely was much larger, but some of it was in fact liquidated during the period in question.


The channel between official assets of the KIA and those of the central bank makes it difficult to appraise exchange market developments. There will be some tendency for changes in central bank net foreign assets to be small, as funds move back and forth through the KIA channel.


This ability, in turn, has arisen partly from the large stocks of both official and private assets held by Kuwaiti nationals. The official assets have provided a deep buffer for intervention against capital flows that have sometimes occurred in this very open regime.