1. The Kuwaiti economy has once again coped well with a difficult regional situation and swings in oil prices, thanks to the authorities’ relentless pursuit of stability-oriented policies and reforms to diversify the economy’s productive base. The implementation of prudent fiscal policies, including restraint in public expenditures, as well as the existence of a sound and well-supervised banking system have helped the economy withstand the financial repercussion of fluctuating oil-related revenues and maintained confidence during and in the period leading to the conflict in the region.

2. The significant decline in oil GDP growth in 2002 was offset to a large extent by a robust and broad-based growth in the non-oil sector, which continued in 2003. This reflected the environment of stable exchange rate and low interest rates, and strong consumer and investor confidence in spite of the regional tension. Stability in the region and the resumption of trade relations with neighboring Iraq is likely to further improve the prospects for the non-oil sector. The boom in the real estate prices, the acceleration of the stock market and the sharp increase in domestic credit demand also attest to the enhanced confidence in the economy’s outlook.

3. Despite the uncertainties and security concerns associated with the Iraq war, which fortunately was short-lived, the authorities persisted in implementing the structural reform agenda, albeit at an understandably slower pace than they had hoped for. Notable advances were made in labor market reform, privatization, and strengthening the financial sector.

4. Looking forward, while the economy’s outlook remains favorable over the medium term, the authorities are aware of the need to address the challenges of increasing employment opportunities for the growing labor force and reducing the economy’s high dependence on oil, while ensuring intergenerational equity. They are determined to take advantage of the current favorable environment and vigorously continue the pursuit of economic policies aimed at strengthening public finance, further diversifying the economy, and promoting private sector investment, both domestic and foreign.

5. Fiscal developments in the past two years affirm the authorities’ long-standing approach to fiscal prudence whose hallmark has been expenditure restraint. In spite of increasing demands on the budget engendered by high oil prices, the authorities maintained a significant degree of spending discipline, which is reflected in a broadly unchanged ratio of current spending to GDP over the past three years. In fact, in 2002/03 when oil revenue increased by some 6 percentage points of GDP, total current spending was reduced by over 2 percentage points of GDP. For the current fiscal year, strict control over wages and public sector hiring is likely to result in a decline in the wage bill relative to GDP. The prudent policy conduct has allowed the government to accumulate further foreign assets in the Reserve Fund for Future Generations.

6. Despite the broadly comfortable fiscal situation, the Kuwaiti authorities are keen to push forward an ambitious fiscal reform strategy to speed up the accumulation of financial assets for future generations on the one hand, and to reduce vulnerability of the budget to oil price shocks on the other. An important step in this regard is the introduction of a three-year rolling budget effective 2005/06 that would target the fiscal position net of exogenous factors. The authorities intend to pursue their fiscal consolidation strategy in a pragmatic and gradual manner to ensure broad support for the planned reforms. Policies to reduce public employment and diversify the revenue base including through the introduction of a value added tax, are best implemented along with the envisaged reforms to promote the role of the private sector, in order to reduce their potential adverse social impact on the population. Priority at this time is accorded to achieving a significant reduction in current spending and improving the efficiency of capital outlays. Consideration is given to control the wage bill by limiting employment in the public sector, as well as better defining capital spending priorities. The authorities have already initiated measures to strengthen budget and expenditure management in line with the recommendations of the Fund technical assistance and are planning on carrying out other Fund recommendations in this regard. On the revenue side, the authorities are considering a number of measures to secure stable sources of revenue. They are planning on raising the tariffs of publicly supplied goods and services for expatriates and Kuwaitis, reforming the corporate income tax to extend its coverage to domestic companies, and eventually introducing the value added tax.

7. Monetary policy in Kuwait continued to be prudent and aimed at maintaining stability of the exchange rate under an open exchange and trade system. Deposit auctions for banks are being used effectively by the Central Bank of Kuwait (CBK) to manage domestic liquidity. The authorities moved to a peg with the US dollar as a step towards establishing a Gulf Cooperation Council monetary union in 2010. Consistent with this objective, the CBK will continue to monitor domestic interest rates and adjust its discount rate in line with developments in global markets with a view to maintaining an interest rate differential on domestic currency-denominated assets. The CBK will also maintain a cautious monetary stance in 2004 to ensure that money and credit growth remains in line with the expansion of non-oil activity.

8. The banking system remains sound and provides a solid supporting environment for the private sector. The system is highly liquid, and well capitalized, regulated, and supervised, and therefore, can withstand significant shocks as highlighted in the FSSA report. Banks activity increased in recent years in line with economic growth, while their financial soundness indicators improved, notably the significant decline in nonperforming loans and increased provisioning. In an effort to maintain the soundness of the sector, the authorities strengthened supervision further in 2003, by adopting a comprehensive regulatory and supervisory system in accordance with international standards and practices. Additional measures were taken in 2003 to enhance risk management and information disclosure in the banking system and a credit bureau was established to help banks better assess credit risks. A recent legislation has also been enacted to bring all Islamic banks under the supervision of the CBK including their licensing. Furthermore, the amended Banking Law, which was approved by the National Assembly in January of this year, will further strengthen the licensing power of the CBK, deepen the financial sector by introducing new financial instruments, and enhance efficiency and competition in the banking system by allowing the establishment of foreign banks in Kuwait. Capital markets have also been deepened through the opening of a parallel stock market, and consideration is given to introducing options, derivatives and convertible bonds.

9. The authorities are committed to accelerating their reform agenda within a four year action plan to reduce the role of the state in the economy and establish a friendly business environment to encourage private investment and attract FDI, and have already initiated efforts to this end. A comprehensive privatization law, which awaits approval by the National Assembly will provide the legal and institutional framework for the government to divest from major state enterprises, including water, electricity, telecommunications, and ports. In the meantime, the authorities are focusing on promoting the role of the private sector in areas that do not require approval by the National Assembly. They have encouraged private sector participation in activities in the oil sector, health, communications, and education services. The approval of the foreign direct investment law by the National Assembly, which allows a 100 percent foreign ownership in Kuwaiti companies and provides incentives for foreign investors, is an important step to attracting foreign direct investment. In addition, the government is proposing a tax law to reduce corporate income tax from 55 to 25 percent on foreign businesses and apply it uniformly on Kuwaiti and foreign companies.

10. Labor reform is another important pillar in the authorities’ economic strategy. Intensive efforts are underway to encourage private employment as a vehicle to reduce the size of the state in the economy and to help absorb the rapidly growing labor force in the country. The recent decision to extend social allowances to the private sector was taken with a view to integrating the labor market and to render private jobs more attractive. The authorities have also provided incentives for Kuwaitis to join the private sector including through putting in place a program to provide vocational training, providing job search allowances for the unemployed, and enhancing job placement services.

11. Finally, progress has been made in improving the quality and dissemination of data. The national accounts have been improved by the adoption of the System of National Accounts and the consumer price index has been revised to reflect new weights based on a recent household expenditure survey. The lag for releasing the national accounts and the CPI data has also been shortened, and the ministry of finance, the ministry of planning, and the central bank are now publishing economic data on their web sites. The authorities are committed to continue to develop economic data in line with the recommendations of Fund technical assistance missions.