Public Information Notice No. 05/63

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Kuwait

May 13, 2005

On April 25, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Kuwait.¹

Background

Kuwait's macroeconomic performance strengthened further in 2003 and 2004 reflecting sharply higher oil prices and production. Real GDP grew at an average annual rate of 8.5 percent during this period, its highest pace in the preceding decade and a half. The rebound was also supported by the spillover effects of the renewed trade relations with Iraq. After taking into account the terms-of-trade gains, per capita income increased by 34.5 percent over the two-year period. Inflation and the rate of unemployment remained low at less than 2 percent and 3.5 percent, respectively. The Kuwaiti stock price index more than doubled in 2003, and increased further by 34 percent in 2004, reflecting higher corporate profits, an improved economic outlook and abundant liquidity.

The central government budgetary position remained strong in 2003/04 and 2004/05 due to significantly higher oil revenues, with annual fiscal surpluses at about 20 percent of GDP. The stance of fiscal policy was expansionary, as a large part of the higher oil revenue was spent on various government programs. Most of the fiscal surplus was transferred to the Reserve Fund for the Future Generation and the General Reserve Fund, ensuring the most rapid asset buildup since the 1990 Gulf war.

Broad money growth accelerated to 7.8 percent in 2003, keeping pace with increases in demand and supported by a rapid increase in private sector credit (21 percent) in an environment of record low interest rates and strengthened domestic economic activity. Monetary conditions tightened in the second half of 2004, as a consequence of the increase in interest rates in line with the rise in the U.S. federal funds rate and the introduction of a ceiling on the credit to deposit ratio. The ceiling was imposed to address prudential concerns regarding the rapid expansion of credit to the private sector over the last three years without a parallel increase in bank deposits. Kuwaiti banks are well capitalized and liquid. The capital adequacy ratio remained comfortable (17.3 percent as of end-September 2004), well above its minimum regulatory level (12 percent). Asset quality improved further and net bank profits and returns on equity also increased significantly. Progress was also made in strengthening the financial sector institutional framework.

With higher oil export receipts, the external current account surplus more than doubled over the two-year period to 29 percent of GDP in 2004. Exports grew at an annual rate of 33.6 percent due to a surge in oil and non-oil exports, the latter supported by a sharp increase in exports and re-exports to Iraq. As in the past, much of the current account surplus was invested abroad by both the public and private sectors. External reserves of the Central Bank of Kuwait remained at comfortable levels. The depreciation of the U.S. dollar against other major currencies and the low inflation in Kuwait have contributed to a depreciation of the dinar by 9 percent in real effective terms during January 2003-October 2004, enhancing the competitiveness of non-oil exports.

Progress has been made on the structural reform front, albeit at a slow pace. The Foreign Investment Law and the associated by-laws are in place, allowing foreigners to own up to 100 percent of Kuwaiti companies in listed sectors. A draft Privatization Law and an amendment to the Tax Law to lower the corporate income tax that applies only to foreign companies from 55 percent to 25 percent are awaiting parliamentary approval. The authorities allowed private sector participation in sectors previously dominated by the public sector. The Kuwaitization policy has been in place since October 2003, entailing training of unskilled Kuwaiti nationals and increasing the proportion of Kuwaitis employed in the private sector by establishing targets (proportional to the workforce) that the nongovernment companies should observe.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They commended the authorities for Kuwait's strong economic rebound and a further strengthening of the macroeconomic position in 2004. The fastest pace of economic expansion since the 1990 Gulf-war, combined with the oil-related terms-of-trade gains, has boosted per capita income and helped build up assets for future generations at a record pace. Directors agreed that, with oil prices likely to remain firm over the medium term, Kuwait's medium-term outlook has improved and is likely to remain favorable, supported by large fiscal and current account surpluses, and low inflation. They observed that generating employment opportunities for the fast-growing Kuwaiti labor force in the domestic private sector and diversifying the structure of the economy are the major medium-term challenges for Kuwait.

Directors encouraged the Kuwaiti authorities to accelerate the pace of structural reforms to further open up the economy for private sector investment in order to address the country's medium-term challenges. Directors welcomed the authorities' awareness of these challenges and their commitment to addressing them, and encouraged them to build the necessary internal consensus. They welcomed the authorities' intention to take advantage of the improved security situation and the opportunities created by reopened economic relations with Iraq, and to reposition Kuwait in its traditional role as a gateway to regions in the north and east. Directors encouraged the authorities to allow the private sector to take a leading role in the associated infrastructure investment projects. In this context, they urged an expeditious passage of the Privatization Law and the amendment to the Tax Law awaiting Parliamentary approval, and a simultaneous broadening of private sector participation in primarily public sector dominated activities. Directors noted that market-based pricing of publicly-provided goods and services could help foster private sector activity, ensure efficient resource allocation, and reduce their burden on the budget.

Directors commended the authorities for the large overall fiscal surpluses recorded in recent years, but expressed concern about the pace of expenditure growth—including the rise in the wage bill—that might be difficult to reverse if that became necessary. They also noted with concern the consequent sharp increase in the non-oil fiscal deficit. Directors observed that increasing the relative size of the public sector undermines the authorities' stated objective to increase the role of the private sector in the economy.

Directors urged the authorities to reduce significantly the non-oil deficit, as a cornerstone of the authorities' medium- and longer-term fiscal strategy. They called for a better targeting of subsidies, putting in place strict controls on new hiring, and not using the public sector as the "employer of last resort." Directors underscored the importance of efficient management of Kuwait's large and fast-growing savings funds and protecting the investments for Kuwait's long-term fiscal sustainability. They therefore welcomed the authorities' intention to push forward reforms aimed at reducing the role of the state in the economy, including its employment role. Directors also strongly supported the authorities' plans to implement a three-year rolling budget by 2006/07 and to strengthen budget and expenditure management. To boost non-oil revenues, several Directors recommended tax reforms in the context of the planned Gulf Cooperation Council union, including the eventual introduction of a value added tax.

Directors commended the authorities for their prudent conduct of monetary policy, which has supported the exchange rate peg and contributed to a remarkable degree of price stability. They noted that the strong non-oil export growth and the recent significant depreciation of the dinar in real effective terms also indicate that the economy remains competitive. Directors supported the authorities' intention to keep the exchange rate peg unchanged until the Gulf Cooperation Council monetary union is established, and to remain open to the choice of the exchange rate regime under the planned monetary union.

Directors noted that the continued rapid expansion of credit for the last three successive years and the strong surge in stock prices, although partly backed by strong economic fundamentals, has posed some risks to the financial system. They agreed that the authorities are rightly concerned about the potential systemic impact of domestic or external shocks on the stability of the financial system, and that they have to implement some precautionary steps to stem the unsustainable pace of credit expansion. Directors observed, however, that the limit on the loans to deposit ratio introduced by the authorities to contain credit expansion in line with the expansion of the banks' deposit base, would constrain market-based operations. Accordingly, they welcomed the authorities' intention to abolish the ceiling on banks' loans to deposit ratio once domestic credit expansion stabilizes. Directors also encouraged the authorities to address the potential risks to the financial system through strengthening of risk-based prudential ratios.

Directors commended the authorities for their effective supervision of the banking system, which has resulted in the development of financially sound, well-managed, and profitable institutions. They noted the substantial progress achieved in further liberalizing the financial system and in strengthening the prudential regulations and supervision, including through implementation of some of the Financial Sector Assessment Program recommendations. While taking note of these significant steps, Directors urged the authorities to secure at the earliest the legal basis for the independence of the capital market authority, the insurance supervision authority, and the Central Bank of Kuwait's supervisory authority. On AML/CFT issues, Directors welcomed the ongoing progress, including the amendments to the regulatory framework that have enabled the sharing of information with foreign counterparts.

Directors emphasized that generating employment for the fast growing Kuwaiti labor force is the most important economic challenge for Kuwait. They supported the authorities' labor market reform strategy aimed at training and providing incentives for development of skills needed by the private sector. However, they urged the authorities to continue applying the Kuwaitization policy flexibly so that the competitiveness and profitability of the private sector are not adversely affected. They stressed the importance of promoting market-based wage flexibility for the Kuwaiti workforce in order to facilitate the integration of the segmented labor markets.

Directors welcomed the progress made in compilation and dissemination of Kuwait's economic statistics. They urged the authorities to reduce the delays in collection and reporting of national income, price indices, and customs data. Directors encouraged the authorities to adopt, in coordination with other GCC countries, common data standards across all sectors as a step toward establishing convergence criteria for the planned monetary union. A few Directors also noted the importance of improving the timeliness and transparency of petroleum-related data.

Directors expressed their appreciation to the Kuwaiti authorities for their generous financial assistance to developing countries, including through the HIPC Initiative, as well as for Kuwait's role in stabilizing the oil market.

It is expected that the next Article IV consultation with Kuwait will be held on the standard 12-month cycle.