Kuwait: Staff Report for 2006 Article IV Consultation

Kuwait’s 2006 Article IV Consultation reports that its macroeconomic performance has been strong in recent years reflecting sharply higher oil and non-oil activity. Over the medium term, Kuwait’s financial position is projected to remain strong. The large external current account and fiscal surpluses are expected to lead to a buildup of a large stock of financial assets for future generations. However, GDP growth is expected to slow down unless the pace of structural reforms accelerates.

Abstract

Kuwait’s 2006 Article IV Consultation reports that its macroeconomic performance has been strong in recent years reflecting sharply higher oil and non-oil activity. Over the medium term, Kuwait’s financial position is projected to remain strong. The large external current account and fiscal surpluses are expected to lead to a buildup of a large stock of financial assets for future generations. However, GDP growth is expected to slow down unless the pace of structural reforms accelerates.

I. Background and Recent Developments

A. Overview 1

1. The consultation discussions were held against a backdrop of strong economic activity, high oil prices and large fiscal and external surpluses, but slow progress in the implementation of structural reforms. The optimism created by high oil prices and output has resulted in booming non-oil activity, a rapidly expanding equity market, and building up of assets for future generations at an accelerated pace, in conjunction with increased allocations for higher public spending.2

2. The authorities’ stated objectives are to achieve a sustainable high rate of non-oil GDP growth to diversify the economy 3 and absorb the fast growing Kuwaiti labor force; ensure intergenerational equity through an accelerated buildup of assets; and guard against potential instability arising from the asset market. In the previous Article IV consultations, the staff made recommendations to speed up structural reforms, and strengthen the budget structure and oversight of the financial sector.

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GCC: Oil GDP as percent of total GDP 1/

(Average during 2000–05)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: Kuwaiti authorities; and Fund staff estimates.1/ Bahrain, Qatar, and the U.A.E. figures include hydrocarbon.

Progress has been made in many of these areas, although implementation of the reform agenda has been slower than expected, in part, due to difficulties in reaching a political consensus. The apparent lack of a comprehensive strategic plan for non-oil sector development has led to piecemeal and ad hoc efforts toward reforms in various areas, which may not enable Kuwait to realize its national objectives, and over time its economic performance could fall behind other GCC countries. Although investment in the economy has increased significantly in recent years, gross domestic investment as a percent of GDP has remained low (14 percent in 2004).

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Domestic Investment in Selected GCC Countries, 2000–05

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: GCC National authorities; and Fund staff estimates.

B. Recent Macroeconomic Developments and Structural Reforms, 2004–05

3. Kuwait’s macroeconomic performance has been strong in 2004 and 2005 (Table 1). Real GDP expanded at an average rate of 7.5 percent, as a result of higher oil production and buoyant non-oil activity (6.4 percent). 4 After taking into account the terms-of-trade gains, per capita GDP increased by 43 percent to more than $26,000 during the two-year period through 2005. Inflation remained low at 1.3 percent in 2004, although it rose to almost 4 percent in 2005,5 due to rising non-oil activity, abundant liquidity, and the delayed effect of the depreciation of the dinar against the euro and yen. The weighted stock price index (WPI) more than tripled during 2003–05, although the pace of increase over the recent two-year period (averaging 39 percent annually) has been slower than in other heavily oil-endowed GCC countries, in part reflecting a tighter monetary policy stance (Box 1).

Table 1.

Kuwait: Selected Economic Indicators, 2001–06

(Quota: SDR 1381.1 million)

(Population: 2.87 million, June 2005)

(Per capita GDP: $26,020, 2005 estimate)

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Sources: Data provided by the authorities; and Fund staff estimates.

GDP data for 2001 are not comparable with GDP data for 2002 and later years. While GDP data for 2001 are based on International Standard Industrial Classification (ISIC) Revision 2, data for 2002 and later years are based on ISIC Revision 3 which covers a wider number of variables and sectors.

For 2005, end-June.

Also includes government entities.

Kuwaiti fiscal year ending March 31.

Excludes SDRs and IMF reserve position.

For 2004, the discrepancy between the savings/investment balance and the current account balance is possibly due to the data being preliminary and may be resolved when the authorities revise the data.

For 2005, average for January to November. The NEER and REER appreciated by 9.2 and 11.7 percent during January-November 2005, respectively.

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Kuwait: GDP Growth and Inflation, 2000–05

(In percent per annum)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: Kuwaiti authorities; and Fund staff estimates.

4. Central government budgetary position strengthened further due to higher oil revenues, with the overall fiscal surplus estimated at 24 percent of GDP in 2004/05 6 (Table 2). Fiscal policy was expansionary in 2004/05, as expenditures increased by more than 14 percent and the non-oil primary deficit in relation to non-oil GDP increased by 4 percentage points to 61 percent. The expansionary fiscal stance was primarily attributable to sharply higher subsidies and transfers and higher capital outlays, while the growth in the wage bill was moderate and expenditures on goods and services declined after a sharp pickup in 2003/04 associated with emergency security spending. Overall, two-thirds of the increase in hydrocarbon revenues is estimated to have been saved in 2004/05, and Kuwait’s government saving rate of 28 percent of GDP in 2004/05 was the highest amongst all GCC countries.

Table 2.

Kuwait: Summary of Government Finance, 2001/02–2005/06 1/

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Sources: Ministry of Finance; Central Bank of Kuwait; and Fund staff estimates and projections.

Coverage of budgetary operations includes the operation of the KIA. Data are on an accrual basis.

Excluded from the national budget presentation. Estimated by the Fund staff.

Excludes revenues from utility tariffs (which are included in the national budget presentation), but includes UN (Iraq) compensations.

Includes the KD 121 million supplementary budget for the emergency spending.

Covers interest payments on the treasury bills and bonds, and on the DCP bonds. Only the latter is included in the national budget presentation.

A breakdown of the relative share of subsidies and transfers is provided in Table 17 of the Statistical Appendix.

Includes KD 192 million one-time transfer of the oil windfall to Kuwaiti nationals.

The Reserve Fund for Future Generations (RFFG) and the General Reserve Fund (GRF).

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GCC Government Savings, 2004

In percent of GDP

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Source: GCC National authorities.

Kuwait Stock Market: Recent Developments and Some Characteristics

Stock prices and market capitalization continued to grow at an accelerated pace. After outperforming most markets in the region in 2003, the Kuwait Stock Exchange (KSE) WPI grew by 15 percent in 2004. The market was more bullish in 2005, helped by the surge in oil prices, expanding liquidity, and strong corporate performance. As a result, the WPI increased by 67 percent. Market capitalization remained stable at 135 percent of GDP in 2004 and grew to the equivalent of 191 percent of GDP in 2005.

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Performance of Stock Price Indices, December 2003–05 1/

Dec. 2003 =100

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: Bloomberg and Kuwait Stock Exchange.1/ End-month data.

Despite the strong growth, the increase in the WPI since 2004 has been moderate in comparison to other GCC markets. The average price index for the stock markets of Arab countries during 2004–05 increased by 215 percent, well above the 93 percent gain in Kuwait during the same period. The valuation of Kuwaiti stocks, as measured by their price/earnings ratio (PER), price/book value ratio (PBR), and dividend yield compares favorably with other markets in the region and even with mature markets.

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Performance of GCC Stock Price Indices, December 2003–December 2005

(December 2003 = 100)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Source: Bloomberg.

The relatively moderate growth in Kuwaiti stock prices results from a combination of strengths and weaknesses. The new prudential and monetary measures introduced by the CBK in 2004 and 2005 have effectively contributed to the deceleration in the rate of private sector credit growth. However, it may also be related to KSE’s relatively weak legal, regulatory, and supervisory framework (as noted in the 2004 FSAP report). Also, according to market participants, a sizable part of listed companies’ profit growth is attributable to capital gains on stock investments.

The financial system is well equipped to withstand any reasonable correction. Strong economic fundamentals, in particular high corporate profitability underpinned by high oil prices have provided a solid basis for the increase in stock prices. However, some level of speculative demand, mainly concentrated in volatile stocks with low market capitalization, is pushing prices beyond some firms’ economic value. In addition, the market remains very sensitive to external factors such as a decline in oil prices, which may substantially reduce corporate profits. Financial stability is based on strong bank capitalization (capital adequacy ratio of 17.3), household borrowings guaranteed against salaries, and moderate exposure to equity market risk (at 9 percent of total loan portfolio, including non-Kuwaiti securities). Nonetheless, in the event of a substantial correction, profitability of financial institutions would significantly decline and non-oil GDP growth would be negatively impacted through wealth and balance sheet effects.

Key Stock Market Indicators 1/

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Source: Bloomberg, Bakheet Financial Advisor, and Global Investment House.

All data as of end–January 2006

5. The external current account registered annual surpluses averaging $25 billion (37 percent of GDP) during 2004–05, primarily on account of high oil revenues. At an annualized rate, exports of oil and oil products increased by over 47 percent, but non-oil export 7 growth slowed down to 15 percent compared with a surge of about 70 percent in 2003 (Table 3), because of slower growth of re-exports to Iraq. Import growth remained high as a result of strong domestic economic activity. Although the services account deficit widened because of higher payments associated with travel and transportation, it was more than offset by higher investment income which surged by 59 percent on an annualized basis. The real effective exchange rate (REER) of the Kuwaiti dinar depreciated by 5 percent in 2004; however, with the strengthening of the U.S. dollar vis-à-vis other major currencies in recent months, the REER appreciated by 11.7 percent during January–November 2005.

Table 3.

Kuwait: Summary Balance of Payments, 2001–10

(In millions of U.S. dollars)

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

Also includes unrecorded exports.

Kuwait Investment Authority, Kuwait Petroleum Corporation, Kuwait Fund for Arab Economic Development, Public Institute for Social Security, Kuwait Airways Corporation, and Bank of Savings and Credit.

CBK, local banks, investment companies, exchange companies, insurance companies, and the nonfinancial private sector.

Includes UN war compensation.

Includes other unclassified private sector flows.

Includes SDRs and IMF reserve position.

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Kuwait: Exchange Rate Movements, January 1995–November 2005

(1990 = 100)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: IMF, Information Notice System; and Central Bank of Kuwait

6. Broad money growth steadily accelerated during 2004–05 and grew by 16.7 percent during the 12-month period through September 2005, despite efforts to tighten monetary policy. This accumulation is attributable to the expansion of credit to the private sector (13.1 percent of broad money) and an increase in net foreign assets (15.7 percent of broad money) (Table 4). The tightening of monetary conditions since the second half of 2004 was pursued by increasing the benchmark interest rate in line with global interest rate developments, by introducing a ceiling on the credit to deposits ratio in July 2004, and by the re-introduction of market-based monetary control mechanisms in August 2005. Banking supervision has strengthened further, and the CBK applied the Basel II capital adequacy requirements for conventional banks effective December 31, 2005.8 The banking sector has been opened further for foreign banks,9 but progress on implementing the remaining FSAP recommendations has slowed down since most pending actions entail legal changes.10

Table 4.

Kuwait: Monetary Survey, 2000–06

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

Excludes SDRs and IMF reserve position.

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Kuwait: Broad Money and Credit to Nongovernment Sector 2000–05 1/

(Twelve month percent change)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

1/ Data through end-October 2005.Source: Kuwaiti authorities.

7. Some progress has been made in private sector participation in the sectors previously dominated by the public sector (particularly in telecommunications, airlines, and infrastructure development). However, several draft laws (including the privatization and competition laws) aimed at promoting a more market-friendly business environment have been awaiting parliamentary approval for a long time due to a lack of political consensus. The Kuwaitization 11 policy has been in place since October 2003, entailing the training of unskilled Kuwaiti nationals and enforcing quotas by imposing penalties to increase the proportion of nationals in the economy.12

II. Report on Discussions

8. The discussions primarily focused on the following four areas which are considered critical for medium- and long-term growth and macroeconomic stability. These include (a) the authorities’ current plan regarding capacity expansion in the hydrocarbon sector and its contributions to the medium-term growth and financial outlook; (b) the fiscal strategy to deal with surging surpluses in a way that contributes to growth through higher investment, fosters an increased role for the private sector in infrastructure development and service delivery, and also addresses intergenerational distribution of wealth; (c) the short- and medium-term challenges for the financial sector, including the potential vulnerabilities arising from the recent asset market developments; and (d) the needed structural reforms to sustain the recent pickup in non-oil activity. The discussions were cast in the context of the near- and medium-term outlook for the Kuwaiti economy and the underpinning policies.

A. Near- and Medium-Term Outlook Remains Strong

9. Real GDP is projected to grow by 6.2 percent in 2006, supported by continued strong oil and non-oil activity. Oil production is expected to remain close to Kuwait’s production capacity of 2.7 mbd. Inflation is expected to decelerate somewhat to 3.5 percent as a result of moderation in rental costs and unchanged administered prices for utilities. Both the external current account and the overall fiscal surpluses are projected at more than 40 percent of GDP,13 despite higher public spending including the full-year effect of the increase in public sector wages by about 10 percent effective July 2005.

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Kuwait: Fiscal and Current Account Surpluses, 2000–10

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: Kuwaiti authorities; Fund staff estimates and projections.

10. Over the medium term (2007–10), Kuwait’s financial position is projected to remain strong. Both the external current account and fiscal balances will remain in large surplus, albeit at modestly declining levels in relation to GDP, mainly reflecting the projected slow decline in oil prices. The fiscal and current account outlooks are expected to be favorably influenced by the returns from the accumulated assets of the Reserve Fund for Future Generations (RFFG). Although the surpluses are expected to remain large despite a moderate decline in oil prices, the authorities observed that there are downside risks to this favorable medium-term financial outlook since it is based on historically high levels of oil price and output assumptions.14 On the fiscal side, although total expenditure in relation to GDP is assumed to remain broadly unchanged over the medium term, these projections entail a significantly lower growth in current outlays than experienced in recent years. Prospects for private investment and non-oil GDP growth are expected to weaken over the medium term in view of the expected slow pace of structural reforms. GDP growth is also expected to decelerate as oil production stabilizes at the projected 3 mbd level, in line with the envisaged oil-sector investment plan.

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Fiscal and External Current Account Outlook Under Alternative Oil Price Scenarios

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: Data provided by the Kuwaiti authorities; and Fund staff estimates and projections.

B. Hydrocarbon Sector: Is the Investment Plan Supportive of Global Oil Market Stability and Kuwait’s Growth Potential?

11. Kuwait’s constructive role in support of oil price stability entailed a rapid expansion of crude output, a comprehensive plan to expand crude and refined oil output, and a boost to gas production for domestic uses (Box 2). Production of crude oil has been increased by 47.5 percent since 2002 in response to growing world demand. A $22 billion self-financed plan to expand crude oil capacity to 3 mbd by 2008, increase refining capacity by 60 percent, and almost double the production of petrochemical products is under implementation. Staff supported these plans and underscored that sustained growth in hydrocarbon output would be important for Kuwait’s medium-term growth outlook and would also contribute to global oil market stability. Forging the necessary political consensus for developing expeditiously the North Fields under “Project Kuwait,” which the authorities have been contemplating since 1997, would be critical for the success of their expansion plans. The authorities now hope that, given the broad political consensus reached on Project Kuwait, parliamentary approval should be possible in early 2006. Kuwait is contributing to oil market transparency by providing data to the Joint Oil Data Initiative (JODI), although there is scope for improving the timeliness of oil data provision.

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Oil Production Increase, 2003–05

(In percent)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: Kuwaiti authorities and EIA.

Hydrocarbon Sector Investment Plans, 2006–11

Kuwait has 99 billion barrels of proven oil reserves, approximately 8 percent of world oil reserves, and is undertaking a broad-based investment plan to realize its hydrocarbon sector potential over the medium and long run. In this context, a $10 billion program to increase crude oil production capacity to 3 mbd by 2008 is under implementation, which is a part of the government’s $22 billion plan and is in line with the long-term plan to increase capacity to 4 mbd by 2020. The long-term expansion plan critically depends on the implementation of “Project Kuwait”, which complements the government’s own plan with an additional investment of $8 billion, jointly with foreign oil companies. Under this project, Kuwait is considering permitting foreign oil companies to invest in upstream production on “buy-back contract” arrangements, which do not involve production sharing, concessions, or the “booking” of reserves by foreign companies. Project Kuwait has been delayed repeatedly due to a lack of political consensus, although there are signs that legislative approval could be secured soon.

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GCC: Planned Crude Oil Production Capacity Increase During 2006–10

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Sources: Country authorities, oil publications, and staff estimates.

As part of its long-term plan, Kuwait is also planning to spend over $10 billion through 2011 to upgrade and increase its petroleum refining capacity. Total refinery capacity is expected to increase from the current level of 0.9 mbd to 1.4 mbd by 2011. The upgrade would increase capacity to produce ultra-low-sulphur fuel, and to process an increasing proportion of domestic heavy and sour crude.

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GCC: Medium-Term Refining Capacity Plans

(In million barrels per day)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

1/ Includes two gas-to-liquids (GTL) projects.Sources: Country authorities, oil market publications, and Fund staff estimates.

Kuwait produces a relatively modest volume of natural gas (around 293 billion cubic feet in 2003), the vast majority of which is “associated gas” that is extracted in conjunction with oil. Kuwait’s natural gas reserves are estimated to be 55 trillion cubic feet, equivalent to 200 years of reserves at the current level of production. Kuwait hopes to significantly increase its use of natural gas, especially in electricity generation, water desalination, and petrochemicals plants, by increasing gas supplies from domestic and imported sources and by reducing the flaring of associated gas to one percent by 2009 from six percent currently.

Development of Kuwait’s petrochemicals sector is being accelerated through an investment plan of $1.5 billion. The plan includes the Olefins project (also called Equate II) to produce ethylene, polyethylene, and ethylene glycol; and the aromatics and styrene plants that are expected to come on stream by 2008. The Equate joint venture is the country’s largest petrochemicals project.

C. Fiscal policy: Improving Resource Management and Ensuring Long-Term Fiscal Viability

12. The overall fiscal position is projected to remain in comfortable surplus over the medium term. Accordingly, the discussion focused on improvements in the structure of the budget by gradually increasing capital expenditure, rationalizing transfers and subsidies, and achieving a better balance between productive expenditure and fiscal savings.15 Staff supported the authorities’ plans to use a part of the higher oil revenue to further improve the country’s physical infrastructure and for investments in health and education. In this context, the staff urged the authorities to promote greater private sector participation in these projects including through public-private-partnerships (PPP). In response to staff’s observation that there was ample room for further boosting public investment by accelerating the implementation of strategically important infrastructure projects, the authorities observed that several such initiatives are under consideration,16 although many of them would require consensus building at the domestic and regional levels.

13. The current favorable fiscal situation is likely to give rise to expenditure pressures, which are already evident in the area of wage and salary increases and higher subsidies and transfers. Staff cautioned against a further widening of the public-private sector wage differential, which would hinder private sector development and further increase the need for wage subsidies to encourage the employment of Kuwaiti nationals in the private sector. While concurring with the staff, the authorities observed that they were trying to fend off such pressures, and the recently announced moderate increase in general salary was a manifestation of their efforts. The authorities also reaffirmed their intention to implement stricter rules for additional recruitment in the public sector, limiting new recruitment to actual staffing needs, and increasingly linking salaries and allowances to individual performance.

14. Progress in the area of income tax reform has stalled, and a revised strategy needs to be explored in light of the current favorable fiscal outlook and political feasibility. The authorities indicated that the envisaged introduction of a new income tax on national companies might not be politically feasible in the current macroeconomic environment. Against this background, staff suggested rationalization of tax and expenditures in order to encourage foreign direct investment and improve efficiency of spending. The measures suggested include: cutting the prevailing 55 percent maximum income tax rate on foreign companies to 15–20 percent in line with other GCC countries; and a significant reduction in large and untargeted subsidies and transfers by rationalizing the system, which accounted for 30 percent of total expenditure in 2004/05.17 The authorities observed that an initiative to introduce a Value Added Tax (VAT) in Kuwait in coordination with other GCC countries was continuing. While supporting this step, staff encouraged the authorities to implement the budgetary reforms they had been contemplating in recent years, including the introduction of a three-year rolling budget; consolidation of the budgetary process by bringing all budgetary chapters under the ministry of finance; and adoption of budget classifications in line with international accounting standards.

15. The large fiscal surpluses have created both opportunities and challenges for addressing a number of medium- and long-term issues facing Kuwait (Box 3). The authorities observed that, although Kuwait’s health and education systems and physical infrastructure were quite good, substantial additional allocations for these sectors were envisaged under the forthcoming new five-year plan.18 The large investment plan to expand hydrocarbon sector activity would be essentially financed by the Kuwait Petroleum Corporation out of its own resources and its joint venture foreign partners. The authorities were of the view that despite sizable additional allocations, consistent with Kuwait’s absorptive and implementation capacity, the fiscal surpluses would still remain very large. Staff underscored that, in the absence of a clear strategy for utilizing the surpluses, pressures would intensify for higher salary increases, a larger size of the government, and larger transfers to Kuwaiti nationals.

16. While noting that such pressures were indeed building up, the authorities observed that the government remained committed to proper utilization of the fiscal surplus. Accordingly, the government contributed an additional 5 percent of revenues (in addition to the statutory contribution of 10 percent of all government revenues) to the RFFG in 2004/05 and are likely to do the same in future. The fiscal surplus was also utilized to pay back a part of the amount borrowed out of the RFFG in the aftermath of the Gulf war and the government plans to expedite the repayment of the remaining amount. While endorsing the authorities’ approach, staff observed that investment income of the RFFG was already significant and, combined with the anticipated large budgetary surpluses, would likely assume greater importance over time. If resources are well managed, given the current medium-term oil price outlook and fiscal stance, achieving fiscal sustainability and the transition to a predominantly non-oil economy in the long run will be much easier. Accordingly, as regards Kuwait Investment Authority (KIA) assets, the staff underscored the importance of strong safeguard arrangements; continuous oversight by the Board of Directors of the KIA and by parliament; and greater transparency in the management of funds by KIA.

Kuwait: How Should the Fiscal Surpluses be Used?

The authorities face the challenge of managing the large fiscal surpluses efficiently. Kuwait has built up sizable investments abroad, despite the setback of the 1990–91 Gulf war. The assets are likely to be built up at a faster pace in the coming years because of higher oil revenues. Accumulated public sector savings is projected to reach 300–400 percent of GDP over the next 5– 8 years, contributing about 15–20 percent of GDP per annum in implicit returns and thereby greatly strengthening Kuwait’s fiscal position even in the event of a decline in oil prices. However, fundamental decisions will have to be made on how to allocate the available funds between productive uses.

uA01fig14

Projection of Public Asset Accumulation, 2005–11

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Source: Fund staff estimates and projections.

Despite the very high level of savings, the level of domestic investment in Kuwait is still rather low and public investment is lagging far behind that of other oil-exporting countries in the region. There appears to be room for further boosting capital expenditure for infrastructure development, health, and education. Efficient government investment in infrastructure and human capital would also contribute to intergenerational equity by enhancing the economy’s long-term growth potential. However, such needs are not likely to be excessive given that Kuwait has already built up good quality infrastructure.

The fiscal surpluses could also be used to recapitalize Kuwait’s social security system (KPISS), which has accumulated significant actuarial deficits in the past. KPISS suffers from a serious structural imbalance because of excessively generous benefits and very low contributions. The last actuarial evaluation of the KPISS done in 2001 indicated that funds of the basic system would be depleted within the next 15 to 25 years if no corrective measures were taken. The actuarial deficit of KPISS has continued to increase since the last valuation, the cumulative actuarial deficit growing from KD 5.5 billion in 1998 to around KD 7 billion in 2004. Therefore, any recapitalization operation should be linked to a fundamental and much-needed reform to guarantee the system’s long-term viability.

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KPISS: Actuarial Projections of Basic Pension System

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Source: Actuarial report prepared by the ILO, 2002.

Finally, a large part of the projected fiscal surpluses should continue to be used in further accumulating financial assets to ensure fiscal sustainability over the long term and to take account of intergenerational equity issues with regard to the intertemporal distribution of Kuwait’s oil wealth. Even though the country’s large natural resource endowments will generate significant government revenues over a long time, economic policy in the long run would need to address the transition to a situation where the oil resources/revenues would be depleted. Investment income from financial savings, if appropriately built up, would help Kuwait to preserve public sector wealth and maintain public services in future.

17. Despite the current surplus position of the Kuwait Public Institution for Social Security (KPISS), it cannot be considered financially sound in the long run.19 The authorities are aware that with payments growing faster than contributions and investment income over the long run, the institution’s financial balance will turn into deficit by the end of the next decade and assets will be eventually depleted, if no corrective measures are taken. The authorities agreed with the staff that the current large fiscal surpluses have created an opportunity to ensure the long-term viability of the KPISS if it is reformed in an appropriate and socially balanced manner. This would entail rationalization and reduction of the overly generous benefits and realignment of contributions in line with the benefits. In the context of such a reform, the staff encouraged the authorities to recapitalize KPISS for the actuarial shortfalls accumulated in the past, as provided under the Social Security Law, thereby establishing a fully-funded and sustainable social security system.

D. Monetary and Financial Sector Policies: Promoting Financial Intermediation While Safeguarding Macroeconomic Stability

18. Monetary policy has been successful in maintaining price stability and the exchange rate peg. Although the underlying equilibrium exchange rate might have appreciated with the positive terms-of-trade shock resulting from higher oil prices, given Kuwait’s limited non-oil export base and its commitments in the context of the GCC, the authorities do not foresee a change in the exchange rate peg to the U.S. dollar in the period leading up to the planned establishment of the monetary union by 2010. The authorities are aware that given the nominal peg to the U.S. dollar, in theory there could be some inflationary pressures in the economy leading to an appreciation of the real exchange rate. However, given Kuwait’s very open trade regime and relatively open labor market, they do not foresee any significant inflationary pressure in the medium term. The pick up in inflation in 2005 would not last very long, the authorities observed, as the supply of housing would increase given the construction boom underway and prices of raw materials should stabilize in the world market. At this point, all options remain open regarding the exchange rate regime under the monetary union.

19. The reintroduction of market-based monetary policy mechanisms also have contributed to maintaining price and exchange rate stability. The auctioning of deposits and issuance of 3-month CBK bonds to mop up excess liquidity helped keep KD deposit rates in line with the CBK’s benchmark rate since August 2005.20 As a result, KD bank deposit rates have increased substantially and the differential with U.S. dollar deposits, which was negative during the first half of 2005, became positive again in the third quarter of the year. While welcoming these developments, staff noted that enhancing effectiveness of the market-based intervention will require closer coordination with fiscal policy – which continues to be the major source of liquidity expansion in the economy - to determine the level of intervention.

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Interest Rate Indicators, 2000–05

Citation: IMF Staff Country Reports 2006, 132; 10.5089/9781451822342.002.A001

Source: Central Bank of Kuwait.

20. The ceiling on the loans-to-deposits ratio achieved its intended objective by dampening the rate of credit growth during 2004–05 21 and thus contributed to the comparatively slower equity price increase. With the deposit growth rate increasing to 16.4 percent, it also restored the balance between the rate of growth of credit and deposits. 22 However, staff noted that despite these positive effects, the ceiling on the loans-to-deposits ratio, in combination with the ceiling on lending rates, might be interfering with the efficient allocation of resources.23 For these reasons, and taking into account the further gains made in strengthening banking supervision, staff recommended that consideration should be given to abolishing the ceiling if the situation remains stable and to ease the ceilings on lending rates within the authority of the CBK. 24 In the authorities’ view, in practice neither of these ceilings were affecting negatively the allocation of financial resources nor were they constraining the activities of banks or nonfinancial firms. However, they observed that the loans-to-deposits ratio was becoming increasingly less effective with the accumulation of excess loanable resources by banks and considered the ceiling a temporary measure to be eliminated once the risk of credit expansion above deposits disappears.

21. The authorities agreed with the staff assessment that the continuing upward trend in the stock price index, despite strong economic fundamentals, posed some risk to the otherwise favorable financial sector outlook. The exposure of banks to the stock market through lending for stock purchases (9.4 percent of domestic credit as of end-October 2005) and the continuing surge in stock prices in the final quarter of 2005 warrant close monitoring. Staff recommended expeditious drafting and passage of the capital market and insurance laws to establish capital market and insurance authorities that will ensure comprehensive oversight of the stock exchange, investment companies, and the insurance sector. Staff also called for strengthening the legal and technical capabilities of the KSE to supervise the investment companies’ portfolio management and for enhancing coordination with the CBK. 25 While broadly agreeing with the staff assessment, the authorities underlined that the stress tests conducted by the CBK, including both direct and indirect equity market risks, showed an adequate and increasing resilience of the banking system against any reasonable market correction. 26 The staff supported the authorities’ intention to introduce a limited deposit guarantee scheme fully funded by contributions from the banks and urged them to implement the scheme expeditiously.

E. Structural Reform: How Can Kuwait Sustain Its Non-Oil Growth Momentum?

22. The current non-oil sector growth momentum is attributable to the optimism associated with the oil price outlook and private sector dynamism observed across the GCC region. The authorities agreed with staff that a critical mass of structural reforms, including amending outdated laws and regulations, would need to be implemented in order to sustain the growth momentum and promote a more market-friendly business environment. In this context, staff supported the authorities’ intention to legislate the Competition Law and implement a legal framework for mega projects under the PPP program. Staff also encouraged the authorities to: implement the remaining recommendations of the 2003 World Bank report on “Administrative Barriers to Investment”, including updating of the Labor Law which dates from 1964; eliminating the discretionary power in the system for the registration of companies; and continuing the customs administration modernization. The authorities acknowledged that creation of a market-friendly environment would also entail the long-awaited parliamentary approval of the Privatization Law. Staff also encouraged the authorities to consider market-based pricing of publicly provided goods and services, particularly for electricity, petroleum products 27 and water to improve resource allocation, encourage private sector participation in these activities, and reduce fiscal subsidies.

23. Various measures were implemented aiming at greater market access and competition and allowing for a broader private sector role in the economy. However, there is a need to cast these measures in the context of a comprehensive reform strategy. The GCC common external tariff at 5 percent rate is in effect since early 2003, and under the Greater Arab Free Trade Area (GAFTA) initiative all import duties were eliminated in January 2005. The GCC countries have agreed to negotiate FTAs with other countries/regional blocks collectively in the future, and an FTA with the European Union is expected to be signed later this year.28 The granting of licenses for three airlines and four more private universities, allowing private companies to operate gas stations, and building two new power plants are also steps in the right direction. The authorities noted that construction of a port on the Boubiyan Island (a joint venture) which is likely to be operational in 2008, privatization of port management, the proposed North-South GCC train line and the initiatives taken under GAFTA would help in their strategy to make Kuwait a regional trade and financial center. Staff also supported the authorities’ efforts to foster foreign direct investment (FDI) by amending the FDI Law of 2003 in line with international best practices.29

24. The authorities are aware that sustaining the current growth momentum will require a flexible application of the Kuwaitization policy and intensified efforts to raise the skills of the Kuwaiti labor force. Staff noted that providing employment in the public sector to alleviate unemployment pressures, as has been done in the past, raises reservation wages for private sector jobs and reduces the incentives for acquiring skills needed for private sector jobs. Accordingly, staff urged the government to limit public sector hiring to essential areas, establish links between public sector wages and productivity, and rationalize public sector benefits. Staff encouraged the authorities to consider positive incentive schemes rather than negative incentives to achieve Kuwaitization goals.30

F. Statistical and Other Issues

25. While the quality of economic data continues to improve, the lack of timely availability of some key economic data on the official websites remains an obstacle for dissemination of information. Significant progress was made in timely provision of the CPI and WPI, and the authorities’ are planning to conduct an investment survey in order to better measure nonfinancial foreign direct investment. Staff encouraged the authorities to improve communications between the various government agencies including the customs agency, the ministry of planning, and the CBK, in order to improve compilation of the national income and balance of payments data. The authorities observed that the planned Establishment Census (expected to be completed in 2006) would enable the construction of a new macroeconomic framework for collection and compilation of national income data. Staff called for improving the coverage of export data, collection of private sector external debt data, and coverage of fiscal data.31 Staff supported the authorities’ intention to work out a road map for subscribing to the Funds’ Special Data Dissemination System (SDDS) and encouraged them to adopt common data standards across all sectors, in collaboration with other GCC countries, to ensure compliance with convergence criteria for the proposed monetary union.

26. Kuwait continued to support low-income countries (LICs) through its sizable external development assistance program. In 2004/05, the Kuwait Fund for Arab Economic Development made commitments of KD 201 million (1.2 percent of GDP) in grants and loans to finance 25 projects in 22 countries. The authorities are considering the Iraqi request to cut Iraqi debt owed to Kuwait, and have committed to provide economic support for Iraq,32 the victims of the Asian tsunami ($100 million)33 and hurricane Katrina ($500 million). Kuwait also disbursed the full amount of its commitment to the HIPC Trust Fund (SDR 4.3 million).

III. Staff Appraisal

27. Kuwait’s macroeconomic performance strengthened further in 2004 and 2005, reflecting higher oil output and prices and strong non-oil activity. The high pace of economic expansion combined with terms of trade gains, boosted per capita income by 78 percent over the last four years. The saving of a significant part of oil price induced budgetary resources contributed to large fiscal and current account surpluses and an accelerated buildup of external assets for future generations. Kuwait’s financial position is also projected to remain strong over the medium term. However, sustaining private sector-led high non-oil growth to absorb the rapidly growing Kuwaiti labor force and diversify the economy remains a major challenge. The apparent lack of a comprehensive strategic plan for non-oil sector development and piecemeal reform efforts, in part due to difficulties in reaching a political consensus, may undermine realization of Kuwait’s national objectives and its relative economic performance may fall behind other GCC countries.

28. Kuwait continues to play a constructive role in support of oil price stability. Oil production has responded strongly to growing world demand and is currently running almost at full capacity. The large investment plan being undertaken to expand crude oil output capacity, increase refining operations, and almost double petrochemicals production demonstrated the authorities’ readiness to support global economic expansion through oil market stability and also realize financial gains for the Kuwaiti population. Staff also urges the authorities to mobilize the required political support to implement the long-delayed Project Kuwait which envisages participation of international oil companies to develop the technically challenging northern oil fields. Staff welcomes Kuwait’s contribution to oil market transparency by providing data to JODI and urges the authorities to improve timeliness of oil data provision.

29. Although Kuwait’s overall fiscal position is projected to remain in comfortable surplus over the medium term, staff urges the authorities to consider improvements in the structure of the budget by gradually increasing capital expenditure, rationalizing subsidies, and achieving a better balance between productive expenditure and fiscal savings. The stance of fiscal policy in 2004/05 and in the current fiscal year, demonstrates the authorities’ resolve to contain recurrent outlays despite intensifying pressures for higher current outlays and a larger size of the public sector. Greater emphasis on capital spending envisaged under the five-year plan is welcome, although given the size of the projected fiscal surplus over the medium term, a comprehensive strategy to deal with the surplus issue will be critical in the face of growing pressures for unproductive spending. While supporting the authorities’ plan to build up RFFG reserves, staff notes that part of the fiscal surpluses should be used to recapitalize the social security system in the context of a reform program to ensure the system’s long-term actuarial soundness. Also key to Kuwait’s long-term fiscal viability will be the efficient management of the rapidly growing public sector savings.

30. Monetary policy has successfully maintained price stability and the exchange rate peg. Staff supports the authorities’ intention to keep the exchange rate peg unchanged until the GCC monetary union is formed and to remain open toward the choice of exchange rate regime under the planned monetary union. The ceiling on the loans-to-deposits ratio introduced in 2004 to tighten monetary conditions has contributed to a deceleration in the rate of credit growth in 2005 and to a rapid buildup of deposits. In view of the gains already made and the diminishing effectiveness of the ceiling, and taking into account the further gains made in strengthening banking supervision, staff recommends that consideration should be given to abolishing the ceiling.

31. The Kuwaiti banking system is financially sound, well managed, and well supervised. While welcoming the steps taken to further strengthen banking supervision and open further the sector for foreign banks, the staff encourages the authorities to push for necessary legal changes required for implementing the FSAP recommendations relating to criminalization of terrorism financing, independence of the CBK, and renewal of interest rate ceilings. The continuing upward trend in the stock price index, despite strong economic fundamentals, poses some risk to the otherwise favorable financial sector outlook. Staff accordingly urges the authorities to implement the FSAP recommendations relating to the stock market and insurance sector. Staff recommends, in particular, an expeditious drafting and passing of the capital market and insurance laws; and establishing the capital market and insurance authorities to ensure comprehensive oversight of the stock exchange, investment companies, and the insurance sector. While the banking system appears to have the ability to withstand any reasonable market correction, there is scope for improved transparency through implementation of more comprehensive accounting standards for other financial and non-financial companies.

32. Staff urges the authorities to cast structural reforms in the context of a comprehensive strategy allowing for a broader private sector role, and to accelerate implementation of these reforms. This would lead to a much higher level of investment and generation of employment in the economy. The progress made in private sector participation in sectors previously dominated by the public sector is in the right direction. In the same spirit, staff encourages the authorities to expedite the updating of outdated laws and regulations to promote a more market-friendly environment, and to move to market-based pricing of electricity, petroleum products, and water. Staff urges the authorities to apply the Kuwaitization policy flexibly so that the competitiveness and profitability of the private sector are not adversely affected, and to intensify their efforts to raise the skills of the Kuwaiti labor force to meet the requirements of the private sector. Staff also encourages the authorities to consider positive incentive schemes rather than negative incentives to achieve Kuwaitization goals.

33. Although the quality of economic data continues to improve, staff urges the authorities for more timely dissemination of some key economic data, particularly on official websites. While Kuwait’s data are adequate for surveillance purposes, the staff encourages the authorities to improve communications between the various government agencies to improve compilation of both the national income and balance of payments statistics. Coordination with other GCC countries to adopt common data standards across all sectors will also be a step toward establishing the convergence criteria for the planned monetary union. Fund technical assistance, perhaps on a GCC-wide basis, would be particularly beneficial.

34. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

Table 5.

Kuwait: Selected Economic Indicators and Illustrative Baseline Scenario, 2001–10

(In percent of GDP, unless otherwise specified)

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Sources: Kuwait authorities; IMF World Economic Outlook, and Fund staff estimates.

GDP data for 2001 are not comparable with GDP data for 2002 and later years. While GDP data for 2001 are based on International Standard Industrial Classification (ISIC) Revision 2, data for 2002 and later years are based on ISIC Revision 3 which covers a wider number of variables and sectors.

Kuwaiti fiscal year ending March 31.

Includes profits of public enterprises.

Also includes government entities.