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Euromoney, April 2015

How to read the outlook for Kuwait and its banking sector? Positive: vast oil wealth, managed, in large part, by one of the world’s most respected sovereign wealth funds. Negative: collapsed oil prices, and a dramatically increased break-even cost for the budget, creating a burden on planned spending. Positive: a sense of progress, at long last, on Kuwait’s much-heralded mega-projects. Negative: Familiar problems of inertia and bureaucracy preventing more getting underway. Positive: the creation of a capital markets regulator and grand ambitions of building a financial hub. Negative: plenty else that needs fixing and modernizing in financial markets, with a real prospect of being left behind if progress is not swiftly made.

It is resplendently self-evident that oil exporters suffer in an era of low oil prices, but what is sometimes lost is the degree of variance between those exporters – especially individual Gulf states – and their particular vulnerabilities. Kuwait, for example, derives 84.7% of its government income from oil, a similar level to Saudi Arabia; but where Saudi’s foreign reserves are equivalent to 96.9% of GDP, Kuwait’s are just 16.7%. “Kuwait is one of the largest losers from the oil price decline, because a very large part of their GDP is oil,” says Raphie Hayat at Rabobank. “They do have a lot of foreign reserves, but not that high compared to other oil producers, and you are getting a lot of tension from that, tension that will continue in the near future, because the government has been relying on higher oil prices over the years.”

Indeed, it is illuminating to look at how the oil price required for a budget breakeven has changed over the years. Deutsche Bank estimates that the figure was $26.40 in 2006, but will be $78.40 this year – which is, conspicuously, a considerably higher figure than the oil price today. Kuwait is not alone in this – the jump is similarly extreme in Saudi Arabia and greater still in the United Arab Emirates – but Kuwait is now feeling the burden of increased spending over the last decade. According to Barclays MENA economist Alia Moubayed, the increase in general government spending in 2014 over the 2000-2010 average was higher in Kuwait than in Saudi, Bahrain , Qatar or the UAE.

 

“There is a very large government in Kuwait and they are paid very well, so wages are a big component,” says Hayat. “Plus, in Kuwait as in several other countries, you have seen it spend heavily to avoid civil unrest during an economic downturn. Keeping the wages high keeps people happy, but it also means you rely on a higher oil price going forward. Then you get a double whammy when oil prices go down: income becomes lower, but expenses can’t go down without creating unrest.”

 

In this environment, it is interesting to look at the progress of Kuwait’s mega-projects. Kuwait has been talking about transformative infrastructure project programmes for many years, and last year appeared to make significant progress for the first time. But how does this fit into a new environment of what must necessarily be tighter spending?

 

The positive view is that all momentum is good and should be welcomed. According to NBK, Kuwait awarded KD7.3 billion ($25 billion) of contracts related to infrastructure development in 2014, quadruple the figure for 2013 and more than the previous three years combined. According to MEED Projects, the total value of Kuwait’s projects market – planned and active – is estimated to be around US$220 billion, at least $48 billion of which is due to be awarded this year. And it’s not just hydrocarbons: projects range from oil and gas (such as a new refinery at Al Zour) to power and water, construction (two new cities, Khairan and Mutla) and transportation (the Mubarak Al-Kabeer Port, the Kuwait Metro and national railroad, a new international airport and the Jaber Al-Ahmad Causeway).

 

Local banks are delighted. “We are receiving many enquiries from international banks, companies and investors regarding the projects market in Kuwait,” says one banker in Kuwait City. “Everyone wants to be part of it.”

 

Dr Elias Bikhazi, chief economist of NBK Group, expects $90 billion of projects to be awarded between this year and next. “Project implementation is being driven by Kuwait’s development plan, and it is significant that parliament recently passed the new five-year development plan with plans to invest around $115 billion over the period,” he says. The new five-year plan he refers to was released in the summer of 2014 and covers 2015-2020.

 

To Bikhazi, this is a win-win situation. “The acceleration in project implementation is having a very strong impact on Kuwait’s non-oil growth,” he says. “The investment push is being met by increased private sector activity, pushing up hiring and investment. We expect non-oil growth to maintain an annual pace of 5-6% in the coming two years at least.”

 

That’s clearly very positive. But can Kuwait be expected to follow through with this ambitious spending when oil prices are so low? NBK analyst Omar Al-Nakib says he expects the government “to reaffirm its commitment to delivering on these targets even in the current environment of low oil prices.” But, as for any Gulf state, that’s surely only sustainable for a limited time.

 

It helps, no doubt, that Kuwait has sought to involve the private sector in these projects rather than just keeping the burden of infrastructure development on the state, and instrumental in this process has been the introduction of a new law last year to regulate all public private partnerships. Where once projects like this were handled by an institution called the Partnerships Technical Bureau, now a new body called the Kuwait Authority for Partnership Projects will take its place, a supposedly independent government body that should have greater executive powers in order to be an effective manager of these projects.

 

“The new PPP law is very important,” says Bikhazi. “The government is relying on the public-private partnership projects for a good part of the investment in the coming years. These projects are to be partly funded by the private sector and are an opportunity to generate more private activity and to reduce the burden on the state.” It was a badly needed law. “It was critical to make some changes to the legal and regulatory environment to ensure smooth implementation and to reassure private investors interested in participating in the PPPs.”

 

For the banks, there’s plenty to be gained from this sudden uptick in activity. “For banks, a pickup in project activity is a boon with opportunities for credit growth and other banking services,” Bikhazi says. “Of course, there is the direct impact of financing and servicing the construction companies.” But that’s not all. “Indirectly, banks will also benefit from the increased economic activity which is likely to benefit various business sectors including business services, employment and retail.”

 

Even the most positive, like Bikhazi, are not blind to the fact that Kuwait has not changed overnight. “The main challenges are bureaucracy and policy inertia. The government has cleared some of the issues in recent years, but there is no question that some challenges remain.” He notes the delay in awarding projects that were bid well above budget, as has happened both with the planned new airport and the Al-Zour oil refinery. “The authorities are scrambling to determine their next move,” he says. “Re-tender; raise budgets; all time-consuming.”

 

Additionally, there’s a question of whether the money is being deployed in the best areas. Hayat, for example, believes that infrastructure investment has to include not just roads and refineries but “improving institutions and technology,” including education.

 

When the IMF conducted its most recent bilateral discussions with Kuwait in December – a process known as Article IV – progress on mega projects was welcomed, but scarcely significant. Indeed, in one of the report’s rare mentions of the subject, it called for a cost-benefit analysis of those projects, reflecting the need for a calm assessment of the country’s fiscal position. “Higher capital spending should be accompanied by improved efficiency of public investment, and integrated with the budget formulation process,” the report said. Drawing lessons from previous national development plans – not all of which have come anywhere near their targets – the state “should set realistic targets that are consistent with the overall economic objectives and increase safeguards to ensure better implementation.”

 

Instead, the IMF devoted considerably more attention to the need for fiscal reform. It called for an effort to contain expenditure growth – particularly subsidies and wages – while increasing non-oil revenue and improving the whole framework within which fiscal policy is conducted.

 

Many in Kuwait’s financial services industry would like to see reform not only in terms of the state’s fiscal position, but the financial markets more broadly.

 

Raghu Mandagolathur is senior vice president for research at Kuwait Financial Centre, also known as Markaz, and he believes it is necessary to modernize the country’s financial markets for three reasons: one, because it helps the government diversify; two, it creates employment; and three, “because of the cost if we lag behind.” One can make an argument that this, as much as eye-catching big-budget mega projects, could be the engine that shakes Kuwait from malaise.

 

To an extent, Kuwait is not only aware of this need and opportunity but actively doing something about it. Kuwait’s Capital Markets Authority has, for example, introduced regulations around the issuance of preference shares, while a new company law – alleviating existing hurdles and bringing flexibility to the process of establishing a business – has been passed by the National Assembly. The Ministry of Commerce, with World Bank help, has been working on a new corporate bankruptcy law, which could help bring about much-needed restructuring in the country’s loss-making investment companies.

 

Better financial markets would create new methods of raising capital, again reducing the burden on the state. “As Kuwait pushes ahead with its diversification agenda under the Kuwait Development Plan, alternative financing channels for various infrastructure projects should be developed,” says Raghu. “In this regard, the development of local debt markets would be beneficial.” The CMA is developing draft laws on sukuk issues, as other Gulf states have already done, so the potential is there for a more active debt market in Kuwait, but it badly lags regional peers today.

 

Bikhazi agrees that “improving Kuwait’s financial markets is an essential part of making the country more diversified and in improving growth prospects over the longer term. More efficient markets, better transparency, and a more robust legal environment are all critical parts.” He, too, believes progress has been made – not least the very existence of the CMA, as well as amendments to its form in 2014. “We now have a CMA that is more effective and is getting to grips with its role.” He believes there have been “notable improvements in corporate governance and financial transparency,” and that timely corporate disclosure has become more commonplace. Like Raghu, he wants to see the development of a fixed income market; furthermore he would like to see the stock exchange privatised.

 

Raghu goes further and presents a precise list of what needs to be done. He believes Kuwait needs to introduce market making in the stock exchange, so as to boost liquidity and investment products like ETFs. He things risk management systems need to be advanced, the credit underwriting process must be enhanced, he believes the bankruptcy law and disclosure requirements must be reformed, he would like to see a corporate governance code implemented, and thinks Kuwait needs an advanced financials filing system like XBRL. He’s not negative, particularly; “a renewed sense of optimism prevails in the Kuwaiti business environment,” he says, noting that each of the Central Bank of Kuwait, Ministry of Commerce and the CMA have all been responsible for implementing reform. He clearly just wants to use the momentum to see the job done properly.

 

Well, he may get more even than that. Kuwait’s five-year development plan, which we tend to associate with the big infrastructure projects, also calls for Kuwait to become a regional trade and financial hub by 2035. There is little available detail on quite how it would do so, and this is the sort of announcement that tends to make international banks and fund managers roll their eyes, wondering how there is room for another hub alongside the Dubai International Financial Centre, Qatar Financial Centre, Bahrain Financial Harbour, King Abdullah Financial District and Abu Dhabi Global Market. “To be honest, I’m a little bit sceptical,” says Hayat at Rabobank. “They have a lot of competition in Dubai. To become a financial hub you don’t just need financial development but institutional development.” But at least there’s a stated intention, and Hayat does say that there is scope to become a hub for Islamic finance, helped by the fact that in Kuwait Finance House it is home to one of the most powerful and influential Islamic institutions in the world.

 

This leads us, inevitably, to the health of the banking sector. Although the economy itself is rather weak – 1.5% GDP growth in 2014, estimated 1.6% in 2015 and 2.1% in 2016, according to Barclays forecasts, in all three cases the weakest of any Gulf state – banks look solid. “Banks in Kuwait are healthy with ample capital and liquidity while profits remain robust,” says Raghu. Net profits rose by 20.2% in 2014, to US$2.26 billion, while loan loss provisions as a percentage of average loans have fallen from 2.1% in 2013 to 1.2% in 2014, he says. In June 2014 the combined capital adequacy ratio for the banking industry was 18.3%, and gross non-performing loans stood at 3.5%, and have been declining. “The legacy issues from the days of the global financial crisis have faded,” adds Bikhazi at NBK. “Asset quality has improved significantly.”

 

There are challenges, though: Bikhazi points out that regulators continue to require relatively high levels of loan-loss provisions, and “profits are being held back by the current low rate environment,” causing Kuwaiti bank profitability to lag that of GCC peers. Raghu notes a different issue. “Loan books of Kuwait banks are concentrated towards a few sectors, especially real estate,” he says. “Going forward with the development of various sectors, banks would need to strengthen their credit assessment capabilities,” particularly across SMEs and micro enterprises.

 

Still, in aggregate they are well placed for new opportunities in Kuwait. It’s now just a question of making sure those opportunities actually appear.

 

 

 

 

 

Chris Wright
Chris Wright
Chris is a journalist specialising in business and financial journalism across Asia, Australia and the Middle East. He is Asia editor for Euromoney magazine and has written for publications including the Financial Times, Institutional Investor, Forbes, Asiamoney, the Australian Financial Review, Discovery Channel Magazine, Qantas: The Australian Way and BRW. He is the author of No More Worlds to Conquer, published by HarperCollins.

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