Fitch upgrades Kuwait to 'AA'; Outlook stable

The Outlooks on both ratings remain Stable. The Short-term foreign currency rating is affirmed at 'F1+' and the Country Ceiling is upgraded to 'AA+' from 'AA'.

Charles Seville, Associate Director in Fitch's Sovereign Group says:

"High oil prices have generated a large revenue windfall, which Kuwait has largely used to strengthen its external balance sheet. Kuwait ran a fiscal surplus of over 40% of GDP in the fiscal year ending in March 2008."

Sovereign wealth funds managed by the long-established Kuwait Investment Authority are accumulating official, non-reserve foreign assets at a rapid rate. The net sovereign foreign asset position, which counts all assets held by the government, including equity assets, is projected to reach $300bn by the end of 2008, almost double its end-2004 level. The net public external creditor position, which excludes equity holdings on the asset side, is as strong as any sovereign rated by Fitch, including Abu Dhabi ('AA/F1+/Stable Outlook'). Although Abu Dhabi is substantially wealthier in per capita terms, it is also more exposed to contingent liabilities in the wider public sector.

The strong external balance sheet offers a sizeable cushion in the event of a major fall in oil prices, which is still the main economic risk. However, even accounting for a large transfer to the social security fund under the present budget, the oil price would have to fall below $50 per barrel to erase the fiscal surplus. Excluding the transfer, the breakeven oil price falls to nearer $25 per barrel.

Since the Central Bank of Kuwait re-pegged the dinar to a basket of currencies in May 2007, the authorities have gained some monetary policy flexibility to manage money supply growth and speculative inflows. The dinar has appreciated by up to 9% against the US dollar under the new regime, although inflation has also continued to rise. Fitch believes that inflation will subside gradually following recent falls in food prices, although it will take time to return to its formerly low level.

The authorities have taken steps to cool growth in bank lending, which as elsewhere in the Gulf has been associated with rapidly growing asset prices, first in equity markets and more recently in real estate. Fitch regards risks to the banking sector and the sovereign from rapid credit growth to be less than elsewhere in the Gulf. Nevertheless, a fund set up earlier this year to assist private citizens with bad debts to the banks has injected unwelcome moral hazard into the system.

Kuwait's more democratic system of decision-making has resulted in public sector reform lagging its Gulf neighbours - Abu Dhabi in particular. Nationals are very dependent on the public sector for employment. A transfer of $20bn to the social security fund in the current budget is designed to address concerns over the long-term sustainability of the generous welfare state, pending a future reform, and a similar-sized transfer is expected in the next fiscal year.

The state-owned oil industry is investing to modestly increase oil and gas production capacity, perhaps making greater use of foreign expertise. Kuwait's economy is oil-dependent to a similar extent to its closest peers, Saudi Arabia ('AA-' (AA minus)/F1+/Stable Outlook') and Abu Dhabi, and the authorities are keen to diversify the economy. Abu Dhabi's public sector enterprises are borrowing to fund ambitious investment projects at home and abroad, and Saudi Arabia is seeking foreign investment and setting up new industrial and commercial poles to create jobs for its rapidly growing workforce. Kuwait's diversification has so far rested more on growing official investment income and the expansion abroad of private sector firms, a less ambitious strategy but one which exposes the sovereign to fewer potential contingent liabilities.

In common with others in the region, Kuwait's rating is depressed by geopolitical risk, with the clearest risk posed by an escalation in tensions between Iran and the international community over its nuclear programme.