Kuwait needs to face up to reform

Kuwait has felt the full effects of the crisis surrounding Iraq. Understandably domestic sentiment has been dominated by security concerns. Kuwait's large holdings of overseas assets have been hurt by the meltdown in global equity markets.

But the economy has also benefited from the war premium built in to oil prices. Oil represents 45% of GDP, 70% of government earnings and 90% of exports and high oil prices have been a welcome boon.

Kuwait has much to lose from instability in neighboring Iraq but there is also a large degree of upside. The reconstruction of Iraq would be a significant positive for the region and in particular Kuwait, not least because Kuwait's port would be an obvious transport hub.

Oil prices and production will continue to be the main driver of growth. A much lower oil price would therefore present challenges. However the Sheikhdom also has a considerable degree of flexibility in its economy. Kuwait's fiscal and external balances historically run significant surpluses.

In the past two years the current account and fiscal balance have both been running surpluses close to the equivalent of one third of GDP. Indeed such is Kuwait's comparative advantage in the oil sector that oil prices would have to have a sustained fall below USD 13 per barrel before either balance falls into deficit.

The cost of producing oil in Kuwait, at USD 1 per barrel, is amongst the lowest in the world and the country has almost 10% of the world's proven reserves (96.5bn barrels, which would last 140 years at current extraction rates).

Furthermore, the government's holdings of foreign assets are estimated to be in excess of USD 70bn - more than twice Kuwait's GDP. All of these factors contributed to the blanket upgrade in Kuwait's sovereign bond rating in 2002 to A2.

Poor health and policy divisions have ensured political paralysis and little movement on the government's 2002-2005 development plan. Ill-health and the advancing age of the emir Sheikh Jabr and crown prince Sheikh Saad have prevented either from providing strong leadership needed to kick start Kuwait's reform process.

Day to day control of the government is in the hands of Sheikh Sabah, the emir's brother. All three senior sheikhs are in their seventies and there is no clear candidate among the younger members of the ruling al Sabah family. The broad public support for the ruling family should ensure a smooth succession to the younger generations but it does reinforce the lack of policy direction in the current government.

Reform is further hamstrung by divisions between the government (which is dominated by the ruling family) and parliament. The latter continues to block key government policy initiatives, including a draft privatisation law and tax law.

In part their objections reflect the opposition to change of a substantial proportion of the population who are comfortable in their government jobs and subsidised living. With parliamentary election's next June a compromise position is unlikely to emerge in the near term.

One important victim of the government's lack of direction has been Project Kuwait. This is the government's blueprint for developing the northern oil fields and a key part of its strategy of a near doubling of Kuwait's total crude production capacity, to 4m bd, by 2005.

The issue of contention is the involvement of international oil companies, who are scheduled to carry the full USD 7bn financing costs and risks required for the development. The opposition's case is based on Kuwait's constitution, which forbids foreign ownership or control of any of the country's national resources.

A compromise is not likely ahead of the parliamentary elections in June. There is no doubt the need for reform is becoming more pressing. Currently the public sector employs around 94% of the Kuwaiti workforce and absorbs almost all Kuwaiti entrants into the labour market each year.

Wages alone already take up almost a third of Kuwait's government revenues. This has increased at the rate of 5% per year over the past five years and, with 50% of the population currently under the age of 15, it will escalate dramatically in the future.

Given Kuwait's strong domestic and external position Kuwait has time to reform, but it should learn the lessons from Saudi Arabia and not become complacent.