Implementation of six-pillar reform plan: The key challenge for Kuwait
Concluding statement of IMF Mission’s visit to Kuwait
KUWAIT: Kuwait’s fiscal and external accounts have been adversely affected by the lower oil prices, and financing needs have emerged. Resilient nonoil activity and strong oversight by the Central Bank of Kuwait have kept the financial sector sound. The key challenge for policymakers is to implement the government’s comprehensive six-pillar reform plan, which aims at promoting fiscal consolidation and boosting private sector growth, diversification, and job creation for nationals. Notwithstanding large buffers that provide policy space to smooth the necessary adjustment, policymakers have initiated important fiscal reforms. These should be sustained to gradually raise fiscal savings, focusing on further rationalizing energy subsidies, containing the wage bill and increasing nonoil revenue, which will create space for higher growth-enhancing capital outlays. Better aligning labor market incentives, promoting higher productivity through privatization and partnerships with the private sector, and further efforts to improve the business climate are key to encourage diversification, private sector development and employment opportunities for nationals. The IMF team highly values the candid and comprehensive discussions with the Kuwaiti authorities. Staff would like to express its sincere gratitude to them for their hospitality and excellent cooperation.
I. Recent Macro-Financial Developments
1. Economic activity in the nonoil sector has continued to expand, albeit at a slower pace, reflecting the impact of lower oil prices. Nonhydrocarbon growth slowed from 5 percent to an estimated 31/2 percent in 2015, as lower confidence weighed on consumption. Notwithstanding an improvement in project implementation under the five-year Development Plan, available indicators point to a further modest softening in nonoil growth this year. However, with oil production recovering after three consecutive years of decline, overall growth is on track to reach about 31/2 in 2016. Inflation, which has been hovering at around 3 percent, is set for an uptick to about 31/2 this year, reflecting the recent gasoline price increases.
2. The financial sector has remained sound and credit conditions favorable. As of June 2016, banks featured high capitalization (capital adequacy ratio of 17.9 percent), robust profitability (return on assets of 1 percent), low nonperforming loans (ratio of 2.4 percent), and high loan-loss provisioning (206 percent coverage). Bank liquidity has improved, supported by a recovery in deposits of government entities. Credit to the private sector has been increasing at a solid pace (about 63/4 percent year-over-year in September 2016), driven mainly by installment loans. Nevertheless, a few sectors to which banks have sizable exposures have shown some weakening. The real estate sector is confronted with a further slowdown in the volume and the value of sales. Nonfinancial corporate earnings have continued to deteriorate. Stock prices have registered broad-based declines since mid-2014 and have remained volatile. Banks’ exposure to Investment Companies has been reduced to 3 percent on average, but the latter are exposed to real estate and local and regional equities.
3. Notwithstanding efforts to contain government spending, the fiscal and external accounts have deteriorated markedly. Dwindling oil revenues have pushed the government’s fiscal balance-excluding investment income and after mandatory transfers to the Future Generations Fund (FGF)-into a large deficit of over 17 percent of GDP in 2015/16, generating significant financing needs. Even when including investment income and before transfers to the FGF, fiscal surpluses have vanished. The underlying (non-oil) fiscal position has nevertheless improved over the past two years, reflecting a decline in the subsidy bill, non-recurrence of one-off spending, and efforts to curtail current expenditure. The composition of government expenditure has also improved in favor of growth-enhancing capital spending. The external current account surplus has also declined significantly, reaching 51/4 percent of GDP in 2015 and is set to fall further to 41/2 percent in 2016
4. Financing needs have thus far been met mainly by drawing down financial buffers, and the government has also started borrowing. The government deficit has been financed mainly through draw down of General Reserve Fund (GRF) assets. The issuance of domestic bonds has been stepped up this year, contributing to a net financing of about KD 1.4 billion year to date-over half the targeted amount for 2016/17. The government has also announced its intention to tap international capital markets to raise up to KD 2.9 billion.
II. Macro-financial Outlook and Risks
5. Growth is expected to gain momentum over the medium term, supported by infrastructure investment. A continued improvement in project implementation under the Kuwait Development Plan will support a gradual recovery in real nonoil GDP growth to about 31/2 percent in 2017 and 4 percent thereafter. Hydrocarbon output is set to increase by 2 percent annually, consistent with investment in the sector. Overall, real GDP growth would reach about 3 percent over the medium term. Inflation is expected to temporarily increase to 41/2 percent in 2017, reflecting energy prices increases in 2016-17, before easing gradually. Higher hydrocarbon exports will lift the current account surplus above 10 percent of GDP by 2021.
6. Kuwait’s fiscal position is projected to improve modestly, but financing needs after transfers to the FGF will remain large. The mission’s baseline scenario assumes oil prices will gradually recover to some $60 by 2021. It takes into account the fiscal impact of the measures recently enacted (increase in gasoline prices and legislated electricity and water price reform) but does not factor in the government’s planned fiscal reforms that have not yet been implemented. Under this baseline scenario, the government fiscal balance after transfers to the FGF is projected to decline from about 171/2 percent of GDP this year to some 13 percent of GDP over the medium term, and cumulative gross financing needs would amount to about KD 35 billion over the next 6 years. These are assumed to be covered by a continued drawdown of assets in the GRF, measured amounts of domestic bond issuance to avoid crowding out private sector investment, and some external borrowing.
7. This macro-fiscal environment is expected to remain broadly supportive of financial stability and credit growth. Growth enhancing capital expenditures will support bank profitability and internal capital generation. While there are downside risks to asset quality, loss absorption buffers are high. Credit growth has been robust, but the significant contribution of installment loans that are secured by salary assignments mitigates concerns of a build-up of financial risks.
8. However, Kuwait would remain significantly exposed to a number of potential external and domestic risks under the baseline scenario. The main risk to the outlook is a further sustained drop in oil prices, which would lead to larger deficits and financing needs. Although the government’s strong credit rating (AA) would enable it to tap international markets, investors’ appetite for GCC bonds could decline in case of large regional financing needs. Kuwait would, therefore, be faced with the tradeoff of issuing more domestic debt, at the risk of squeezing domestic liquidity and crowding out private sector credit, or allowing readily available buffers to run lower. Other risks include reform setbacks or slow Development Plan implementation, which could entail a larger fiscal deficit and slower growth. Heightened security risks could also affect investor confidence and more volatile global financial conditions could increase borrowing costs. The mission and the authorities’ banking stress tests indicate that the financial system is resilient to severe solvency and liquidity shocks, but a protracted period of lower oil prices has the potential to increase liquidity and credit risks, exacerbate stock market volatility, and negatively affect real estate prices.
III. Policy Discussion A. Anchoring macroeconomic stability
9. A gradual but sustained fiscal effort is needed to reduce vulnerabilities and bring government savings closer to levels consistent with intergenerational equity. Under the mission’s baseline projections, rising gross government debt and large fiscal financing needs make the fiscal position more vulnerable to shocks. In addition, the nonoil balance is projected to diverge from levels consistent with intergenerational equity by some 20 percent of nonoil GDP by 2021, calling for a significant additional increase in fiscal saving. At the same time, large fiscal buffers and low debt allow for a gradual approach to consolidation that supports growth and financial sector stability.
10. The mission recommends an adjustment path that will allow for achieving the intergenerational equity over a ten-year period. This would entail reducing the government deficit (after transfer to the FGF) from a projected 171/2 percent of GDP in 2015/16 to about 7 percent by 2021 and broadly eliminating this deficit by 2025. This proposed path, which strikes a balance between achieving necessary fiscal savings and mitigating the impact of adjustment on growth, can be achieved through a combination of the main expenditure and revenue reforms included in the government’s six-pillar reform plan.
11. The mission supports the authorities’ plan to raise non-hydrocarbon revenue as part of the medium-term fiscal consolidation program. This includes introducing a value-added tax (VAT) at a rate of 5 percent, as well as raising excise tax on tobacco and sugary drinks. These measures will be implemented in the context of the regional GCC agreement and could generate additional revenue in the order of 13/4 percent of GDP. The mission encourages the authorities to step up tax administration reforms so as to implement the VAT as early as possible. In addition, the authorities are preparing a business profit tax reform that will apply to all enterprises. At a rate of 10 percent, it could raise an additional 11/2 percent of GDP in revenue by 2020. Staff also supports the government’s plans to gradually adjust the price of government services.
12. Further subsidy reform is critical. The government has taken important steps this year to raise gasoline and utility prices. The mission encourages the authorities to move ahead with their plans to further rationalize energy subsidies (estimated to have amounted to about 6 percent of GDP in 2015/16). Gradual implementation would help reduce the inflationary impact and give time to businesses to adjust. Mitigating measures should be designed so as to target the most vulnerable households and promote energy efficiency. A well-designed communication strategy, highlighting the budgetary costs and distortions generated by energy subsidies, as well as their distributional impact and the planned compensatory measures, would help build consensus for these reforms.
13. The mission welcomes the authorities’ intention to control the wage bill as part of the medium-term fiscal effort. The borrowing from diversified investors and drawdowns in GRF assets would help maintain adequate buffers, take advantage of the current favorable borrowing conditions, and mitigate potential negative macro-financial implications.
17. Continued progress toward strengthening the institutional and legal frameworks for debt management and increased transparency would help. The establishment of a high-level debt committee, backed by the creation of new debt management unit (DMU) at the ministry of finance, provides a strong basis for coordination across all relevant government bodies. Further efforts are ongoing to clarify responsibilities and improve institutional cooperation and fully operationalize the DMU. It would also be important to put in place a mediumterm debt strategy. The mission welcomes the authorities’ intention to address legal hurdles that constrain the amounts and type of instruments that can be issued, including Sukuk, hence helping broaden the investor base. Maintaining a debt ceiling would, however, help maintain fiscal discipline. Improved disclosure of the government’s assets and liabilities, moving to more comprehensive fiscal accounts, and improving timeliness of intra-year budgetary execution data would help strengthen investor confidence and reduce borrowing costs. Promoting a deep and liquid government debt market that facilitates private debt issuance is important to foster capital market and private sector development. Introducing regular auctions, communicating transparently, and developing secondary markets would help in this regard.
18. The mission considers the peg to an undisclosed basket appropriate, as it has provided an effective nominal anchor. The authorities are fully committed to the current exchange rate regime. The modest depreciation against the dollar since mid2014 (7 percent) on account of having a basket rather than dollar peg has been helpful during a period of dollar strength. Staff’s external sector assessment suggests a moderate current account gap, the bulk of which would be closed by increasing fiscal savings as recommended over the medium term. The mission notes that over the longer term, as the economy diversifies, the benefits of greater exchange rate flexibility may increase.
B. Safeguarding financial stability
19. The CBK has been proactive in strengthening regulatory oversight and mitigating financial stability risks. Banks are under Basel III regulations for capital, liquidity, and leverage. Macro-prudential measures-to prevent excessive debt build up by households and limit banks’ exposure to real estate and equities-are being enforced to minimize systemic risks. A new corporate governance framework has also recently been introduced. In light of the potential risks from a sustained further decline in oil prices, and given high loan concentrations, common exposures and interconnectedness of the financial system, the CBK’s enhanced surveillance bodes well for early identification of financial stability risks. In particular, the mission welcomes the ongoing initiatives to strengthen stress testing techniques, develop early warning indicators, step up efforts to monitor deposit trends, and identify emerging pressures in corporate and household balance sheets.
20. A number of steps would help further strengthen financial sector resilience. The mission underscored that a formal framework for operationalizing macro-prudential measures would help maintain appropriate coverage of risks over time and the balance between preempting the buildup of excessive risks and alleviating possible liquidity shocks and pro-cyclicality in credit and asset markets. Reforms to strengthen the insolvency regime are ongoing in collaboration with the World Bank. Progress on this front, combined with judicial reforms to introduce commercial courts and expedite enforcement, would help minimize losses-given-default. While the CBK is well-equipped to deal with possible liquidity shortages-as it applies five liquidity requirement instruments, including the liquidity coverage ratio and the net stable funding ratio-developing a liquidity forecasting framework would also help anticipate potential system-wide pressures. Sustaining efforts to streamline noncore bank activities where corporate structures are complex would facilitate risk identification and effective supervision.
21. Strengthening the crisis management framework would promote market discipline and safeguard fiscal resources. A special resolution regime for banks has not yet been put in place. A blanket guarantee covers all banking system deposits. Consideration should be given to establishing frameworks that allow for least-cost and effective resolution in the event of stress in the banking system. Formalizing arrangements between key regulatory institutions would also help improve crisis preparedness. The mission welcomes the advanced arrangements for technical cooperation with the IMF in these areas. authorities’ proposed wage reform is intended to help simplify and harmonize the wage structure and centralize wage policy decisions. In view of the already high total government wage bill-including in comparison with peers-the reform should be designed in a way to ensure that the overall wage bill does not rise further, and that any initial costs of moving to the new wage grid are offset by savings in allowances and bonuses. Moreover, to allow better control over future wage growth, the reform should provide flexibility in setting wage increases. Over time, this would help reduce the wage gap with the private sector, reduce nationals’ reservation wages, enhance private sector competitiveness, and facilitate diversification of the economy in a way that maximizes the participation of nationals. The mission also encourages the authorities to limit employment growth, while promoting private sector job creation for nationals, and communicate early on about its objectives to help reset expectations.
14. Further streamlining other current spending will create space for higher growth-enhancing investment. Containing transfers to enterprises and households and goods and services would contribute to the adjustment effort, while allowing for higher capital outlays. This would in turn mitigate the contractionary impact of fiscal adjustment, provided it is accompanied by public investment management reforms to improve implementation capacity and efficiency. In this regard, the mission welcomes the efforts underway to better prioritize projects through strengthened appraisal processes, with emphasis on encouraging diversification and employment opportunities for nationals. Systematic ex-post evaluation and effective implementation of the anti-corruption framework are also important.
15. A medium-term fiscal framework is needed to guide fiscal consolidation and reduce implementation risks. The mission welcomes the ongoing efforts to strengthen budget planning, including the move from the annual incremental budgets to medium-term budgets starting in FY2017/18 and the planned introduction of three-year expenditure ceilings. These reforms should take place within the context of a comprehensive medium-term framework, guided by an overarching long-term fiscal policy objective (for example based on intergenerational equity considerations) and setting a consistent path for an intermediary target (a nonoil fiscal balance objective would help delink spending from oil revenue volatility). In this context, the mission underscores the importance of developing a top-down approach, strengthening budget processes-including by reducing the fragmentation of the investment budget-and expenditure control mechanisms, and developing reporting and accountability mechanisms.
16. Borrowing and investment decisions should be guided by a comprehensive asset-liability management strategy that takes into account macro-financial implications. The appropriate mix between the various borrowing and investment options should be guided by a systematic assessment of their relative costs and benefits, including that of maintaining liquid buffers as insurance against shocks. The macro-financial impact of these options should also be assessed carefully, taking into consideration the implications of building up debt and the impact of borrowing on domestic liquidity, credit, and central Note: bank reserves. In this regard, coordination with CBK will remain important. A balanced approach entailing domestic and external
C. Private sector-led growth and economic diversification
22. Creating jobs for a growing young national population will require addressing labor market inefficiencies and encouraging private sector development and diversification. Labor market and civil service reforms should aim at improving incentives for nationals to take up jobs in the private sector, including by managing expectations about the limited future availability of public sector jobs. Sustaining the recent efforts to streamline public sector wages and benefits would also contribute to making the private sector more attractive and encourage the hiring of nationals by private-sector firms. Boosting the private sector demand for nationals’ labor will also require fostering an education system that reduces skill mismatches.
23. The mission welcomes the focus of the government’s six-pillar reform plan on privatization and PPPs. Building on stronger legal and institutional frameworks, the government aims at a greater use of these options to enhance the role of the private sector in the economy and upgrade infrastructure. While the privatization program is still in its early stages, several Build-Operate-Transfer projects are in the pipeline. Continued progress toward establishing clear timetables, advancing preparatory work to strengthen underlying assets, and promoting a transparent environment that fosters competition and reduces hidden costs and contingent liabilities for the government will help stimulate private sector investment and boost productivity.
24. Further improving the business environment is important to foster diversification. Recent efforts include the opening of the Kuwait Business Center, a one-stop window that will help streamline registration and licensing procedures, and steps toward digitalizing administrative procedures. Given the central role SMEs can play in economic diversification and job creation, a similar initiative is planned for SMEs. The mission emphasized the need to sustain reforms to facilitate access to land and finance, reduce the burden of administrative procedures and excessive regulations, and foster competition. It welcomed the authorities’ intention to improve the functioning of the National Fund for SMEs development to free up resources for small businesses. Consideration could be given to reviewing the hurdles to SMEs’ access to finance, including the potential impact of the cap on lending rate spreads.