Kuwait: good just got better

In its most recent Economic and Financial Review, National Bank of Kuwait notes that with war in Iraq over and stability returning to the region, an already promising picture for the Kuwaiti economy looks better than ever.

The growth possibilities are substantial as Iraq rebuilds and promises to play an important role in the economy of the region in the coming few years. For Kuwait this not only means increased trade and investment opportunities in the neighbor to the north, but more importantly improved prospects for internal growth in an era of increased regional stability.

This year has already proved to be very positive as the price of oil remained strong and the local equity market surged on strong investor confidence. Private sector activity that was already showing strong signs of recovery in 2002, benefited from increased demand for logistical supplies and support services by coalition forces.

However, these positive indicators can conceal the real challenges that lie ahead. For Kuwait's economy to make the most of the improved conditions, a bold attitude must be embraced to deepen the steps towards economic reforms that have been studied in great detail.

The foreign direct investment law passed in 2000 is only now being implemented with the issuing of the supporting regulations early in 2003. Still pending are reforms of the tax regime as well as the long-awaited privatization law. Pushing those along urgently this year can pave the way for real growth in the coming years, the only sure way to satisfy the ever-increasing need to create employment opportunities for nationals.

Progress on other liberalization initiatives has also been slow including most importantly Project Kuwait which has been delayed for far too long. In 2003 this initiative to allow international oil companies to participate in the development and operation of northern oil fields has been revived and promises to provide concrete results before the year is out. Still, the political factor will continue to cast a cloud of uncertainty on its prospects despite its strategic importance in helping Kuwait maintain its share in the global oil market.

Even before the optimism born of the overthrow of the Saddam regime in Iraq, Kuwait was already benefiting from an improved economic environment. Driving the growth in economic activity has been an expansionary fiscal policy, which has boosted both current and capital spending over the last two years. A highly liquid environment benefiting from UN compensations for losses due to the 1990 Iraqi invasion has also been a boon, especially in driving activity in the local stock and real estate markets.

Economic activity recovered in 2002 as gross domestic product (GDP) grew by 2.3% to KD 10.74 billion despite a drop in value added from crude oil production. Traditional private sector activities including wholesale and retail trade, real estate and business services, formed an important part of this pick-up, though the public sector continued to be an important driver as well.

Overall, growth in non-oil GDP accelerated to 6.2% raising its share of the total to 55%. Oil GDP shrank mildly despite higher oil prices as Kuwait reduced its crude oil production in line with cuts in the OPEC quota. The recovery in petroleum refining offset part of this drop as repairs to Kuwait's largest refinery that was damaged by a June 2000 accident were completed in September of last year.

NBK expects the sector's output should be even higher this year barring a sharp drop in refining margins as it operated below its original capacity during most of last year.

Kuwaiti crude averaged $23.6 per barrel in 2002. The price rose further during 1Q03 averaging $28.5 as war in Iraq appeared more likely before weakening in the months after the war. Kuwait's crude oil production recorded its highest levels in years once war broke out and during the following weeks as authorities pushed production to 2.4 million barrels per day (mbd), near the country's sustainable production capacity.

Driving the growth in non-oil GDP was a relatively strong domestic demand that increased by 11.3% during 2002. Growth in private consumption continued to show resilience, growing substantially during last year.

Underlying this robust growth is the increased hiring of Kuwaitis by the government coupled with an improving economic picture that helped boost household spending in general. NBK's report notes that the rapid expansion in consumer lending supported by positive demographic trends has added further fuel.

Government spending and gross capital formation also contributed to growth, though the latter still accounts for a small share of GDP. Mirroring the solid growth in consumer and government spending was the surge in imports which saw the most rapid increase in a decade.
Per capita GNP fell by 7.2% to KD 4,966 on the back of a drop in investment income from abroad and fast growth in the population. However, per capita consumption continued to grow at its 5-year average.

Kuwait achieved a current account surplus equal to 12% of GDP during 2002. Though smaller than in recent years, it was still the third highest in two decades. Lower earnings from overseas investments and oil receipts were behind this drop. Still, the current account surplus allowed the public and private sectors to continue amassing substantial investments overseas.

The official holdings of foreign assets increased by 10% of GDP bringing the total accumulation since 1995 to KD 14 billion or 140% of GDP. This has no doubt been a factor behind the decision of international rating agencies to upgrade the sovereign credit rating of the State of Kuwait last year.

NBK estimates that a budget surplus before the allocation for the Reserve Fund for Future Generations (RFFG) equivalent to 12% of GDP added further confidence. A higher price for Kuwait's oil more than made up for the reduced production. Meanwhile, non-oil revenues continued to make impressive progress towards reducing reliance on oil revenues in the government budget, though reduced UNCC payments to the public sector obscured that trend.

Growth in government expenditures moderated following the rapid growth in the previous two years, though critical capital spending continued to gain momentum. The implementation of development projects formed an essential part of the government's economic program to revive the domestic economy.

NBK expects another surplus in fiscal year 2003/04 is highly likely, though it could be smaller. The proposed draft budget for FY03/04, which still awaits National Assembly approval, projects a large deficit based on its conservative $15 per barrel assumption for Kuwait export crude. The price of crude oil is likely to average $22-26 per barrel. This could produce a surplus if prices are in the high end of the range.

The economic recovery increased the demand for expatriate labor that contributed to the rapid growth in the country's labor force in 2002. Meanwhile, the net increase in the number of jobs held by Kuwaitis was similar to the prior year's, though it remained below what is required to keep pace with the large number of Kuwaitis entering the labor market. This has pushed more Kuwaitis to register for newly introduced unemployment benefits and promises to be a continuing problem in the years ahead. Officially, the unemployment rate among nationals stood at 6.4% at the end of 2002.

The proposed solution has been to encourage the private sector to hire more young Kuwaitis. However, limitations continue to make such a project very difficult, at least as long as the public sector continues to offer more secure employment. Employment growth in the private sector remained a trickle accounting for 8% of new jobs. NBK believes that the recent law promoting the employment of Kuwaitis in the private sector is not likely to see immediate results due to the large number of Kuwaiti labor market entrants and the relatively small size of the private sector.

Money supply growth moderated in 2002 with growth coming in less than the previous year's record level. A drop in net foreign assets, reflecting increased outflows from the system starting in the second half of 2002, was a primary factor behind this moderation.

Balance of payments statistics suggest that some of this outflow was toward foreign portfolio investments. But, a faster pace of remittances by foreign workers may have also been a reason as geopolitical tensions escalated towards year end. The trend continued through the first quarter of 2003, keeping a lid on money supply growth despite strong growth in lending to the private sector, higher government spending and continued United Nations Compensations Committee (UNCC) payments.

For more than three years, UNCC payments to the private sector have made for a very liquid environment. Disruptions in Iraqi oil exports caused payments to drop in 2002, but private sector receipts were not reduced by much.

In contrast, the government received a large share of the payments made in 2003 through April. Future payments are likely to be much reduced following the recent UN resolution to reduce the share of compensations from Iraqi oil revenues to 5%.

Interest rates continued to decline during the year. The CBK reduced the discount rate by a total of one percentage point in two equal cuts in June and November bringing the rate down to 3.25%. The cuts, coupled with excess liquidity in the system, forced rates on loans and deposits to follow suit.

After twenty-seven years of linking the Kuwaiti dinar exchange rate to a basket of currencies, Kuwait decided to link the dinar to the US dollar under a flexible peg from the beginning of 2003. The move is in preparation for the adoption of a single GCC currency in 2010. The CBK will retain a band of plus or minus 3.5% in order to ensure a smooth evolution of the historic behavior of the KD that has traded within the specified band since liberation. For the last six years, the KD has fluctuated within a 3% band against the US dollar.

Meanwhile, the country continued to enjoy a low rate of inflation that declined substantially in 2002, with the last three quarters seeing relatively low inflation of under 1%. Currency stability and a deflationary global environment were primarily behind this trend as inflation in Kuwait tends to be mostly imported.

NBK notes another step undertaken by Kuwait and other Gulf Cooperation Council (GCC) members towards achieving greater economic integration among them, namely the agreement reached last year to bring forward the proposed customs union to take effect at the start of 2003.

The important decision was followed by a National Assembly action approving the measure in April 2003. Kuwait began to implement the union as of May 2003. The customs union unifies customs duties of the six-member GCC and promises to promote increased inter-regional trade.

In addition, the establishment of the customs union will give the GCC countries a better position to negotiate trade deals with other countries, which could result in the elimination of tariffs for aluminum and petrochemicals destined to the European Union (EU). Kuwait, like other GCC countries has plans to expand its petrochemicals industry with two new projects to build an aromatics plant and to double the capacity of the existing olefins plant.

The NBK report suggests that ample liquidity and low interest rates were main factors behind the pick up in domestic investment activity, primarily in real estate and equity markets. Real estate sales rose to their highest level in years, both in the apartments and commercial property market as well as in private residential property.

Lending by the government-owned Savings and Credit Bank (SCB), that provides subsidized loans to new home owners, continued to bolster activity, with supplemental loans from commercial banks giving an additional boost.

Consequently, there was an increase in the number of construction permits issued by the Kuwait Municipality was accompanied by a surge in the construction of homes and apartment buildings.
The NBK report also reviewed the strong performance of the local equity market, where the general Kuwait Stock Exchange (KSE) index shot up by 57% during the first five months of 2003 following a 39% increase in 2002, despite the fact that growth in corporate profits was tapering off.

The advance was accompanied by a surge in turnover, with the average value of shares traded per day more than doubling for 2002 as a whole and tripling in the month of May relative to 2001. This performance seemed to defy expectations that pessimism will prevail at a time of a possible war in the region.

The market, however, appeared willing to discount the risks and focused instead on the new opportunities that will open up in the region once the US-led war in Iraq was over. Investors were confident the war would be quick and bring much needed stability and increased growth opportunities for Kuwaiti corporations.