NBK on the Kuwait economic outlook

Favorable domestic trends continued to gain momentum in Kuwait during 2003, with growth in business activity becoming more widespread and strengthening overall economic growth.

Higher oil revenues accommodated an increase in government spending, which acted as the pump primer for the economy, while other factors served as growth catalysts.

The rapid conclusion of the war in Iraq cleared the uncertainties that were clouding the economic outlook the previous year, quickly dissipating fears of a possible disruption in the flow of oil or business activity within Kuwait.

To the contrary, lucrative logistics and supply contracts from foreign military forces stationed in Kuwait invigorated domestic demand and business activity. The overthrow of Iraq's hostile regime also removed the psychological threat it posed to Kuwait's security.

This added to a generally better sense of confidence and optimism about future business prospects, particularly with the resumption of trade and commercial relations with Iraq.

The real estate and stock markets were direct beneficiaries of this increased optimism, with activity and prices in both markets rising sharply. Low interest rates and excess liquidity in the banking system facilitated the flow of investments into these markets.

Oil revenues were higher as oil prices remained strong for most of 2003 and crude oil production increased. The price of OPEC's benchmark basket of crude hovered close to the upper limit targeted by the organization and well above the conservative price assumed in Kuwait's official budget.

Kuwait export crude averaged $27 a barrel, 14 percent higher than the previous year, while crude oil production rose by 19 percent. As a result, oil revenues grew by 12 percent during the first nine months of the fiscal year.

Non-oil revenues were also boosted by higher customs duties, tax revenues and United Nations Compensations Committee payments for losses due to the 1990 Iraqi invasion.

Growth in oil revenues facilitated the government's pursuit of an expansionary fiscal policy. Growth in government spending reached 3.8 percent per annum during fiscal year 2002/03 and 5.4 percent during the first nine months of fiscal year 2003/04.

Excluding transfers spending growth came higher at 8.8 percent and 7.8 percent for the two periods, respectively. The budget for the current fiscal year, which ends in March 2004, is expected to see a surplus as large as the previous fiscal year, which amounted to KD 1.3 billion, before the allocation of 10 percent of budget revenues to the Reserve Fund for Future Generations.

Capital spending continued to be a high priority in the government's economic policy. Spending on development and maintenance projects increased by 13.5 percent in fiscal year 2002/03, though it remained well below budget due to slow implementation and over budgeting.

Only 70 percent of the budget was spent, in line with the year before. Growth in government spending has to a large extent contributed to a rise in gross capital formation by 7.6 percent in 2002. We estimate that capital spending this fiscal year will show an increase as well, given that the budget allocation was raised by 8 percent.

Though not reflected in the State budget, capital spending in the oil sector has also been a beneficiary of increased focus on development projects. The country's crude oil production capacity was tested in the spring during the war in Iraq, when output surged to its highest level in years.

This highlighted the urgency of increasing the country's capacity and improving efficiency. An ambitious capital expenditure plan is presently being implemented, which includes expanding export facilities and upgrading gathering centers and pipelines. In the downstream sector, plans for two major petrochemicals projects are in the advanced stage, with at least one approaching implementation in 2004.

Strong oil prices and higher production levels will mean substantial growth in gross domestic product (GDP) in 2003. Non-oil activities have also witnessed accelerating growth that could top the 6.6 percent increase in value added during 2002. This means that overall growth will be substantial in both nominal and real terms, since lower crude oil production in 2002 limited the increase in nominal GDP to only 2.3 percent to reach KD 10.7 billion.

This drop in crude output was partially offset by an 11 percent increase in the average price of oil and a rise in petroleum refining output as the country's refining capacity was restored to its level prior to a June 2000 accident at the country's largest refinery.

Non-oil sectors benefited from a surge in activity following the end of the war in Iraq and the resumption of trade with the northern neighbor. Optimism now pervades economic life with a number of Kuwaiti businesses already moving to do business in Iraq.

Foreign companies vying to do business in Iraq also started using Kuwait as a base or transit point, boosting demand for domestic goods and services. The increased sense of stability in Kuwait also served to improve the business environment domestically.

Leading private sector areas that have witnessed an upturn are wholesale and retail trade, real estate and business services, manufacturing, transport, storage and communication, and healthcare.

These sectors were already experiencing an acceleration in activity during 2002. Unofficial indicators suggest growth gained momentum on the back of higher consumer and government spending and Iraq-related business. The latter could be a bigger boon to business once the security issue in Iraq is resolved and reconstruction efforts progress.

Kuwait's current account should show a higher surplus in 2003 from higher oil and refinery exports. In 2002, the current account surplus fell by half to KD 1.3 billion, or 12 percent of GDP, as a result of reduced oil production and a surge in imports. Lower investment income from abroad also contributed to the decline.

Stabilization of interest rates and a general improvement in global markets and corporate profits should be reflected in higher investment income for 2003.

UNCC payments to the private sector (individuals and companies) provided a smaller stimulus to domestic activity, liquidity and investment compared to the previous three years. Payments dropped significantly in 2003, falling to KD 194 million from KD 410 million in 2002 and KD 435 million in 2001.

Further reductions are expected in the coming years following a UN Security Council resolution reducing the share of Iraqi oil revenues set aside for compensation from 25 percent to 5 percent to accommodate the country's enormous need for funds to finance reconstruction.

In 2003, the government enacted new implementing regulations governing the foreign direct investment law that was passed two years earlier. The rules will open the way for foreign capital and know-how to make critical investments in the country, benefiting from a 10-year tax holiday and 100 percent ownership.

However, for serious long-term investors tax reform remains essential. The government has drafted a law reducing corporate taxes from their current high level, but the proposal has yet to be discussed by the National Assembly.

In addition, the government has also drafted a personal income tax law which envisions imposing income taxes on all residents. Despite the strong rationale for such a law, it is doubtful to make it through a populist parliament.

Private consumption expenditures continued to be propelled by the same factors that were behind their accelerated growth in 2002, which, at 11 percent, was the highest since 1996. Increased hiring in both the public and private sectors helped boost household spending in general.

This was further facilitated by a rapid expansion in consumer loans, in addition to demographic trends of a fast growing population and rapid household formation. The increase in spending is best reflected by a 24 percent rise in imports (net of re-exports) during the first three quarters of 2003, following a 12 percent increase in 2002.

Figures for trade with the US, UK, Japan and Germany point to a strong increase in vehicle imports. Though some may be related to Iraq and a rise in trucking business, a good part has been for local buyers, most of whom resort to bank loans to finance car purchases.

The economic recovery caused an increase in the demand for expatriate labor, whose growth could exceed 7 percent for 2003. Though most of the growth is among unskilled laborers, an increase in the number of professionals and teachers was also seen during the first three quarters of 2003.

Meanwhile, Kuwaitization and the national labor support law appear to have made some impact on Kuwaiti employment over the last year, most noticeably in managerial and supervisory positions.

Nonetheless, unemployment among Kuwaitis continues to grow as neither public nor private hiring can absorb all new entrants into the job market.