Kuwait's Sovereign outlook remains stable but The Financial Sector faces a tough year ahead

However, downward pressure on corporate and bank ratings has increased with the emergence of liquidity and funding constraints, declines in asset values and weaker economic growth prospects for 2009-10.

Kuwait's sovereign ratings reflect the robustness of the budget to oil price shocks and the substantial financial flexibility afforded by the large net asset position of the government and large net external creditor position of the country as a whole.

Recent fiscal performance has been very strong and although the weakness of international oil markets will translate into sharply lower budget revenue this year the public finances are likely to remain in comparatively good shape.

Capital Intelligence expects the central government budget, including estimated investment income, to record a surplus of 16.5% of GDP in the fiscal year ending in March 2009. Under unchanged policies and assuming an average oil price of USD45 a barrel, the surplus would turn to deficit in fiscal year 2009/10.

Such an outcome is far from inevitable, however, as the government has several expenditure-reducing options, the easiest of which would be to scale down or suspend exceptional transfers to the social security fund to cover its actuarial deficit (budgeted at 14% of GDP in the current fiscal year). According to Capital Intelligence's estimates, a pause in the recapitalisation programme alone would reduce the break-even price for the budget to about USD37 a barrel.

Risks to the public finances from the private sector have increased but look manageable. The net fiscal cost of measures to cushion the impact of the global financial crisis, which include measures to help the banking sector and the establishment of a public sector fund to support the stockmarket, has so far been modest. The government is under pressure, however, to provide greater support, including to investors, but should weigh carefully the risk of creating additional moral hazards before doing so.

Capital Intelligence views the government's balance sheet to be sufficiently strong to enable it to cope with severe economic shocks, including a prolonged period of low oil prices or the realisation of contingent liabilities in the financial sector. Government debt, all of which is domestic, currently amounts to just over 5% of GDP, while fiscal reserves are believed to be in excess of 150% of GDP and could be drawn down to cover a large reduction in revenue or to meet unanticipated expenditure needs.

The operating environment for banks and corporates has weakened significantly in recent months with the intensification of the global financial crisis and sudden decline in the price of oil. The global scramble for liquidity and changes in exchange rate expectations contributed to a significant withdrawal of foreign deposits from Kuwait's banking system in the final quarter of 2008 and added to funding pressures in the interbank money market. At the same time, local and international stockmarkets plummeted and local and regional property prices began to decline from high levels, putting upward
pressure on corporate leverage ratios and reducing the net worth of individuals.

Kuwait's banking sector entered the crisis from a position of strength, with strong capital adequacy
ratios, good profitability and a positive net foreign asset position. The authorities have moved quickly to safeguard financial stability by explicitly guaranteeing bank deposits, placing deposits with local banks and lengthening the maturity of refinancing operations.

Kuwaiti banks nevertheless face a tough year ahead. The strong growth of private sector credit over the past few years coupled with banks' increasing exposure (direct and indirect) to stock and real estate markets has made banks more vulnerable to downturns in economic activity and asset prices, and Capital Intelligence expects to see the share of non-performing loans in total loans increase over the next year or so (from a reasonably low base) and some deterioration in profitability and capitalisation.

Downward pressure on financial strength ratings, which indicate standalone creditworthiness, is likely to increase but the long-term issuer ratings of the main banks are less likely to change owing to the very strong ability and willingness of the government to provide adequate financial support should such support be needed.

Of more immediate concern is the creditworthiness of firms in the investment industry, where
refinancing and liquidity risks are more pronounced and could lead to negative rating actions during 2009. Loans from domestic banks and foreign borrowing are among the main sources of financing for Kuwait's 95 investment companies, accounting for about 15% and 20%, respectively, of total balance sheet liabilities of USD66 billion (about 43% of GDP) at end-November. The drive by international
banks to reduce leverage and risk is likely to make it more difficult for investment companies, more than 20 of which are rated by Capital Intelligence, to refinance these obligations as they fall due. Repayment concerns are exacerbated by price declines and reduced trading liquidity in many markets and, for some companies, relatively large exposure to illiquid asset classes such as real estate and private equity, all of which make it harder to divest assets in a timely fashion in order to meet financial obligations. Similar problems are being faced by non-financial corporations with significant exposure to the stockmarket, including some real estate companies.

The authorities are considering ways of easing investment companies' liquidity constraints but concrete proposals have yet to emerge, and the authorities did not intervene to prevent Global Investment House, the largest investment company, from defaulting on a USD200mn syndicated loan in December 2008. One option reportedly under consideration is the establishment of a repurchase-type facility under which investment companies would exchange assets for government debt that would then be used to secure loans from domestic banks and repay debt falling due. In the absence of official support, Capital Intelligence expects other investment companies to come under financial strain this year, and some may be forced to merge.