Mission Concluding Statement 

September 26, 2014

I. INTRODUCTION

Economic activity has picked up further in 2014. The fiscal and external current accounts continue to show large surpluses supported by high oil prices and production. Although the current fiscal position is strong, spending rigidities and reliance on oil revenues have highlighted fiscal risks. Containing current spending growth by restraining the wage bill and reforming subsidies are important for ensuring fiscal sustainability. Economic diversification is a policy priority and this will require reforms to improve the business environment, public investment efficiency, governance, and institutional and policy making frameworks, as well as encouraging entrepreneurship, including by developing the small and medium-sized enterprises (SMEs) sector.

Effective and prudent regulation by the central bank has ensured high capitalization and provisioning, and maintained banking system stability. Risks to the financial system from investment companies are currently contained helped by a combination of regulatory oversight, deleveraging, and restructuring. A few companies continue to make losses. Enhancing the macroprudential policy framework would strengthen financial system stability.

II. Recent Developments

1. Economic activity has picked up in 2014. Non-oil growth is projected to accelerate to 3.5 percent in 2014 from an estimated 2.8 percent in 2013, driven by a combination of continued increase in domestic consumption and some pick-up in government capital spending and private investment. Flat oil production in 2014 over 2013 would keep the overall real GDP growth positive at 1.3 percent, compared with -0.2 percent in 2013. The average inflation rate is forecast to remain about 3 percent in 2014. The current account surplus is expected to remain high at about 38 percent of GDP in 2014.

2. A fiscal surplus of 26 percent of GDP is projected in 2014 supported by high oil prices, but with increases in salaries and subsidies it will be down from about 35 percent in 2013. Total spending is projected to rise by 25 percent in the FY 2014/15 budget, reflecting both increased current and capital expenditures.

III. Outlook and Risks

3. Kuwait’s current near-term economic outlook is positive. Non-oil GDP growth in Kuwait is expected to further accelerate to 4.0 percent in 2015, and is projected to increase to 4.5–5.0 percent in the medium term in the baseline scenario, supported by government investment in infrastructure and oil sector, private investment, and consumption. Inflation is projected to increase to 3.5 percent in 2015. A moderate increase in oil production is expected to further support overall growth. The external current account and fiscal surpluses are projected to remain high but would decline over the medium term, as oil prices are projected to gradually fall.

4. An enduring political agreement on the reform agenda is required to improve the overall business confidence and the investment climate to achieve the projected non-oil growth rates. The government’s new five-year Development Plan (DP, 2015–19) is scheduled to be placed before the parliament shortly. Given underexecution of spending and delays in initiating and completing priority projects in the previous plan, the new plan should set realistic targets that are consistent with the overall economic objectives. Monitoring and ensuring implementation of the DP are also important to sustain investment and support high non-oil growth over the medium term.

5. Downside risks to the outlook could also arise from lower global oil demand and prices. Staff’s analysis shows that a $20 decline in oil prices relative to the baseline would result in reversing of the fiscal position (excluding investment income) from a surplus to a deficit in the medium term. However, while large fiscal buffers would allow the government to smooth public spending in the medium term in the event of a sustained oil price drop, this would come at the cost of lower saving for future generations. The breakeven oil price—the price needed to balance the budget at current expenditure levels—has risen over the past few years and is estimated at $75 in 2014/15 (excluding investment income).¹ All these factors would adversely affect long-term fiscal sustainability, warranting restraint in current spending growth. On the other hand, an increase in geopolitical risks and unrest in key oil exporting countries pose upside risks to Kuwait’s hydrocarbon production and prices.

6. Surges in global financial market volatility would likely have limited effects on the financial health of banks. Banks have direct exposures to the cyclical real estate sector and equity (24 percent of total assets), thus exposing them to a downturn in real estate and equity prices. In addition, banks have 19 percent of total assets in real estate and equity collateral. The high capitalization and provisioning levels, however, provide substantial loss absorption capacity that has been validated by the central bank’s stress test results, but there could be pockets of vulnerabilities that the central bank is proactively monitoring and mitigating by using macroprudential tools. An abrupt change in global financial market conditions could however increase market and funding risks for investment companies (ICs), forcing further deleveraging of proprietary positions for some of them, as well as adversely affecting fiduciary assets.

IV. Policy Challenges

Macroeconomic Policy Mix

7. The fiscal stance for 2014 is expansionary and thereafter indicates consolidation. The non-oil primary deficit is projected to exceed the long-term sustainable level indicated by intergenerational equity considerations by 5 percent of GDP by 2019. Fiscal restraint in the medium term is, therefore needed to help reduce fiscal vulnerabilities and bring the fiscal stance closer to benchmark sustainability level.

8. A gradual reduction in the non-oil fiscal deficit over the medium term can be obtained with a number of options to contain current expenditure growth. These include containing the increase in public jobs and compensation, including benefits; a gradual phasing-out of subsidies (9 percent of GDP), with a social safety net and other mitigating measures, supported by a well-designed communication strategy; and a review of various transfers to enterprises and households, goods and services spending, and other current expenditures. Subjecting Kuwaiti companies to corporate tax and revising fees for public services are sources to increase non-oil revenues. The implementation of the proposed measures to contain the non-oil deficit, however, should commence in the near term, since delays would result in the widening of this deficit and require larger adjustment in the future.

9. The government has started implementing reforms to contain current spending. Subsidies have been eliminated for diesel (with potential saving of 0.5 percent of GDP), and the government is in advanced stages of sending a proposal to the cabinet for reducing subsidies for kerosene and electricity. Moreover, the government recently rationalized some allowances for Kuwaitis traveling for healthcare abroad.

10. The government is also considering proposals on public sector wage reform. The objectives include revamping the current payroll system, linking performance management with promotions, standardizing salaries across public sector jobs, and moving to a system of salary indexation with periodic rebasing. This development is welcome as it would simplify the wage structure. However, reducing the wage gap between public and private jobs to create incentives for nationals to take up private sector jobs, and restraining the increase in public sector employment should be part of the reform.

11. Prioritizing capital expenditure towards social and physical infrastructure projects would help strengthen growth. Higher capital spending should be accompanied by improved efficiency of public investment, consistent with the broader diversification goals, and integrated with the budget formulation process. Actions in the near term to improve efficiency would include adopting a general strategy to modernize the procurement system, raising the oversight of public investment projects by increasing the transparency on decisions related to such projects, preparing an infrastructure needs assessment and effectively implementing the anti-corruption framework, and assessing the state of the public investment management system.

12. The government should make more rapid progress in establishing a fiscal policy framework. It would entail developing a medium-term macroeconomic framework, which would provide multiyear projections of key economic variables, a medium-term fiscal framework (MTFF), which would provide multiyear targets or ceilings on aggregate fiscal variables; and a medium-term expenditure framework, which would translate the overall budget envelope into a set of multiyear expenditure ceilings and policies for the main spending ministries. This will lay a strong foundation for the reform of the public finance management underway with the help of the World Bank. The macro-fiscal unit can play an important role in this process.

13. The monetary policy stance remains accommodative. Bank credit continues to grow, supported by strong deposit growth. Current liquidity conditions are supportive of the demand for credit, and monetary operations continue to focus primarily on absorption of surplus liquidity through conventional and Islamic instruments. The peg to a basket provides a credible monetary anchor.

Fostering Sustainable Growth

14. Efforts by the government to diversify the economy are paramount to reduce Kuwait’s dependence on oil and to generate jobs for nationals. Although removing impediments in physical, legal, and business infrastructure is important, aligning incentives of firms, workers, and nationals is the missing link in the diversification strategy. Improvements in the quality of education, and skill development, and changes to the balance of incentives for tradable/non-tradable production and public/private sector employment are essential to change the incentive structure. Developing SMEs, with the support of the KD 2 billion National Fund for SME Development, is important as a source of job creation for nationals, economic diversification–including promoting non-oil exports–, and sustainable growth.

Strengthening Financial Stability and Intermediation

15. Banks are amply capitalized and liquid with stable profits, reflecting prudent regulations by the Central Bank of Kuwait (CBK). Banks have a combined capital adequacy ratio of 18.3 percent, falling gross non-performing loans (NPLs) of 3.5 percent, and a growing provisioning ratio (general plus specific provisions) of 139 percent at end-June 2014.

16. The CBK has been proactive in introducing regulations to mitigate potential risks. It has introduced Basel III capital regulations for conventional and the growing Islamic bank segments, including a framework for domestic systemically important banks, which will increase the regulatory capital of banks significantly. Regulations on leverage and short term liquidity are in advanced stages of preparation. In line with international practices, the central bank introduced a loan-to-value ratio for residential real estate for investment purposes of individuals in November 2013, to limit financial stability risks, which the mission welcomes. Staff observed that activity has been recently increasing in investment properties and commercial real estate segments of the real estate market, which the central bank is closely watching and ready to use macroprudential tools when appropriate, to limit potential stability risks to the banking system arising from this sector.

17. The systemic risk from ICs is contained, but the sector is vulnerable to swings in real estate and financial markets. Stronger regulatory oversight by the Capital Markets Authority is needed to strengthen this sector and engender consolidation. The completion of the new draft corporate bankruptcy law could help expedite the restructuring of some loss making ICs, and implementation of the corporate governance code by June 2016 would help strengthen the sector.

18. Continued coordination between the regulatory and supervisory bodies will facilitate effective monitoring and management of potential systemic risks. Such a framework should include (i) strengthening the institutional arrangements for policy making and coordination through a formal mandate; (ii) further strengthening the Early Warning System for identifying and monitoring systemic risks, with macro stress testing becoming an integral part of systemic surveillance; (iii) continued enhancement of the existing macroprudential toolkit; and (iv) implementing structural measures over the medium term, including further developing domestic interbank money and debt markets to support liquidity management, modernizing the insolvency regimes and supporting judiciary framework, and strengthening crisis management and resolution systems. The CBK should be provided with enhanced powers in this regard.

19. As Kuwait advances its diversification agenda, banks will need to reorient business strategies towards assessing private sector credit risks and maintain a more diversified asset portfolio. Greater focus on improving the risk management of the growing Islamic banks’ segment becomes especially important. Developing domestic debt markets would bring important benefits, such as raising funding for the large infrastructure investment programs. Expediting the legal framework for the issuance of sukuk would help deepen this market.

20. The mission is encouraged by the authorities’ efforts to strengthen the Anti Money Laundering/Combating of Financing of Terrorism (AML/CFT) framework, and looks forward to their continuing to work with the Financial Action Task Force.

Other Issues

21. The mission acknowledges the progress made in improving Kuwait’s statistical system, and encourages the authorities to further their efforts in improving all areas of economic data, including through cooperation with GCC Stat.

The mission thanks the authorities for their excellent collaboration, and open and constructive discussions.

Kuwait: Selected Economic Indicators, 2007–15     (Quota: SDR 1,381.1 million) (Population: 3.97 million; Dec. 2013) (Per capita GDP: $44,700; 2013 estimate) (Poverty rate: n.a.) Main export: oil               Prel. Proj.   2007 2008 2009 2010 2011 2012 2013 2014 2015   Oil and gas sector                   Total oil and gas exports (billions of U.S. dollars) 59.1 82.6 48.9 61.8 96.7 112.9 108.5 106.0 102.7 Average oil export price (U.S. dollars/barrel) 68.4 92.2 61.5 77.7 103.3 107.1 105.5 104.7 101.4 Crude oil production (millions of barrels/day) 2.57 2.68 2.26 2.31 2.66 2.98 2.93 2.93 2.94   (Annual percentage change, unless otherwise indicated) National accounts and prices                     Nominal GDP (market prices, in billions of Kuwaiti dinar) 32.6 39.6 30.5 33.1 42.5 48.7 49.9 50.7 51.1 Nominal GDP (market prices, in billions of U.S. dollars) 114.7 147.4 106.0 115.4 154.1 174.1 175.8 179.6 181.1 Real GDP (at factor cost) 6.0 2.5 -7.1 -2.4 10.2 8.3 -0.2 1.3 1.7 Real oil GDP -4.7 6.5 -12.9 0.5 14.6 12.2 -1.8 0.0 0.3 Real non-oil GDP 14.0 0.0 -3.2 -4.1 3.6 1.9 2.8 3.5 4.0 CPI inflation (average) 5.5 6.3 4.6 4.5 4.9 3.2 2.7 3.0 3.5 Unemployment rate (Kuwaiti nationals) 6.1 4.9 3.6 2.9 3.4 … … … …                       (Percent of GDP at market prices) Investment and savings                   Investment 20.5 17.6 18.0 17.9 13.5 12.8 14.1 15.9 17.3 Public 3.3 3.5 4.8 5.7 4.7 4.0 4.0 5.3 6.2 Private1 17.1 14.1 13.2 12.2 8.8 8.8 10.1 10.7 11.1 Gross national savings 57.2 58.5 42.3 51.1 57.1 58.7 56.6 53.6 52.8 Public 53.5 47.2 50.9 53.5 58.0 58.3 55.7 54.5 52.3 Private 1 3.8 11.3 -8.6 -2.4 -0.9 0.3 0.8 -0.9 0.6                       (Percent of GDP at market prices) Budgetary operations2                   Revenue 67.1 65.1 64.6 69.0 75.3 73.3 71.9 71.9 71.5 Oil 51.6 52.8 53.3 56.3 64.8 61.2 58.5 57.0 54.8 Non-oil, of which: 15.5 12.3 11.3 12.8 10.5 12.1 13.4 14.9 16.7 Investment income 12.3 9.4 8.4 9.0 7.3 8.6 9.1 10.4 12.1 Expenditures 28.1 48.5 35.7 45.3 38.2 38.8 37.2 45.6 44.4 Expense 3 24.0 44.1 31.0 39.5 33.6 34.6 33.1 39.9 37.9 Capital 4.1 4.4 4.7 5.8 4.6 4.3 4.1 5.7 6.5 Balance 39.0 16.5 28.9 23.8 37.2 34.5 34.8 26.3 27.1 Domestic financing -3.1 -4.5 -1.8 1.1 -0.2 -1.9 -3.3 -1.8 -1.8 External financing -35.9 -12.0 -27.1 -24.9 -37.0 -32.6 -31.5 -24.5 -25.3 Non-oil balance (percent of non-oil GDP) 4 -50.2 -56.4 -79.2 -98.8 -97.3 -101.6 -87.8 -106.7 -101.7 Total gross debt (calendar year-end)5 7.0 5.4 6.7 6.2 4.6 3.6 3.2 3.3 3.3   (Percent change; unless otherwise indicated) Money and credit                   Net foreign assets6 3.1 33.0 24.1 -0.5 22.0 20.6 11.1 11.1 8.4 Claims on nongovernment sector 35.1 16.6 6.2 1.8 2.3 3.1 7.3 6.9 7.3 Kuwaiti dinar 3-month deposit rate (year average; in percent) 5.0 3.4 1.7 1.3 1.1 1.0 0.8 0.9 ... Stock market unweighted index (annual percent change)7 24.7 -38.0 -10.0 -0.7 -16.4 2.1 27.2 ... ...                                           (Billions of U.S. dollars, unless otherwise indicated) External sector                   Exports of goods 62.6 87.0 54.4 67.1 102.9 119.7 115.7 113.4 110.5 Of which: non-oil exports 3.5 4.4 5.5 5.3 6.2 6.7 7.1 7.4 7.8 Annual percentage change 6.4 25.1 26.5 -3.4 15.3 9.5 5.9 3.7 5.9 Imports of goods -19.1 -22.9 -18.5 -19.6 -22.6 -24.2 -25.9 -27.7 -29.6 Current account 42.2 60.2 28.3 36.7 65.8 78.7 69.6 67.7 64.3 Percent of GDP 36.8 40.9 26.7 31.8 42.7 45.2 39.6 37.7 35.5 International reserve assets8 16.7 17.2 20.4 21.4 26.0 29.0 32.2 38.5 40.6 In months of imports of goods and services 6.2 5.4 7.6 7.2 7.5 7.7 8.2 9.1 9.0                     Memorandum items:                   Exchange rate (U.S. dollar per KD, period average) 3.52 3.72 3.48 3.49 3.63 3.57 3.53 ... ... Nominal effective exchange rate (NEER, period average) -2.0 2.9 -3.6 -0.3 0.5 1.6 1.0 ... ... Real effective exchange rate (REER, period average) -0.4 8.1 -1.0 1.1 1.7 3.2 0.8 ... ... Sovereign rating (S&P) AA- AA- AA- AA- AA AA AA ... ...                                         Sources: Data provided by the authorities; and IMF staff estimates and projections. 1 Also includes government entities.           2 Kuwaiti fiscal year ending March 31, e.g. 2007 refers to fiscal year 2007/08. 3 In 2006/07 KD 2 billion was transferred to partly cover the actuarial deficit of the Public Pension Fund. In 2008/09, KD 5.5 billion was transferred. KD 1.1 billion is budgeted for each year from 2010/11 to 2014/15. 4 Excludes investment income and pension recapitalization, and after transfers for FGF (fiscal year).   5 Excludes debt of Kuwait's SWF related to asset management operations.   6 Excludes SDRs and IMF reserve position. 7 Change in the KSE as of May 9 2012 for 2012. 8 Does not include external assets held by Kuwait Investment Authority. 1 The production level is assumed at 2.925 million barrels a day in 2014. Transfers to the Futures Generations Fund are not considered in the calculations as they are treated as below-the-line transactions in fiscal accounts.