Capitalising on gains: Leveraging resources and a strong economy to diversify the market and secure future needs

The discovery of Kuwait’s Burgan oilfield in 1938 set the state on a path of development that has made it one of the richest nations in the world, and its buoyant oil revenues, years of budget surpluses, and a young and growing population combine to underwrite the nation’s future economic expansion. Alongside Qatar and the UAE, Kuwait boasts the joint-highest sovereign ratings from the major ratings agencies, its GDP per capita ranks among the highest globally, and its citizens enjoy a public spending programme that grants them access to housing, health care, fuel, electricity and water for free or at highly subsidised rates. In recent years the government has deployed a long-term strategy to shift the economy away from a reliance on oil revenue and provide more opportunities for private sector involvement in economic development. However, such a transition will not be easy; most Kuwaiti citizens work for the government, and the public sector’s economic dominance is ingrained in Kuwaiti society.

STRATEGY: After years of operating without an overall development strategy, Kuwait came into the limelight in 2009 when it became the first client of Tony Blair Associates, a consultancy recently established by the former UK prime minister. The National Development Plan (NDP) – revealed the following year and the first of its kind for Kuwait since the 1980s – is largely a product of this consultation, and its size and scope have given investors a clearer idea of the opportunities that will become available as Kuwait reshapes its economy. In 2010 the National Assembly approved the first phase of the NDP through FY 2013/14. Consisting of some 1100 projects, including a number of very large ones, the plan came with a spending schedule of up to KD30bn ($107.1bn), around half of which is expected to come from investors. Moreover, the current NDP is only the first of five successive five-year plans that, in addition to raising oil and natural gas production, are aimed at diversifying the economy beyond petroleum by establishing Kuwait as a regional trade and financial centre, revitalising the private sector and promoting human capital development. Projects included in the first five-year plan are capacity-building works on roads, ports and airports, a new business centre (Silk City) with an estimated cost of $77bn, an international-standard offshore tourism resort, residential developments, a metro and railway system linked to other GCC nations, and KD20bn ($71.4bn) in oil sector investments to lift production capacity.

Implementation of the NDP is an important strategic development. However, transforming strategy into reality is not always straightforward in Kuwait, where one of the most democratic political systems in the region can easily block or delay projects, and some observers claim that it is likely that less than 30% of the first five-year plan will be completed by the time it ends in 2014. Nevertheless, the government recently announced that $5.4bn will be allocated for development spending under the plan for 2013/14, the majority of which will be directed towards infrastructure development in the power and water sectors.

PRIVATISATION: To realise its vision for Kuwait as adumbrated by the NDP, the government intends to utilise the capital and expertise of the private sector. Its main instrument is the public-private partnership (PPP) model, the legal framework of which was created in 2008.

The promulgation of a PPP Law (Law. No 7/2008) and its executive regulations was followed in 2010 by the new Independent Water and Power I(W)PP Law (Law No. 39/2010), which elaborates in greater detail the building and implementation requirements to be applied to companies undertaking power and desalination projects as part of a PPP. Within a few weeks of the I(W)PP law’s adoption, the Partnerships Technical Bureau (PTB), which was set up in 2008 to oversee the implementation of PPP projects, appointed a transaction advisor for the nation’s first IWPP project.

The Az Zour North IWPP project Phase 1 is the first stage of a five-phase development plan that will establish a power and water production complex with a total capacity of 4800 MW and 1.3bn litres per day. In April 2013 the PTB announced that it was seeking expressions of interest for the second phase of the Az Zour North I(W)PP with a deadline of June 2013. While the Az Zour development has progressed, the PTB has already started the tendering process for its second IWPP project in Al Khiran, near the southern border with Saudi Arabia. Both projects represent milestones for Kuwait’s PTB, and their successful implementation augurs well for government plans to boost the private sector’s role in areas previously covered solely by the public purse. As well as co-opting the private sector into new developments, Kuwait is also moving to open up some existing public assets to private investment. In 2010 it passed a privatisation law providing the legal framework by which it might divest itself of selected public sector enterprises and established a Supreme Council of Privatisation to implement its provisions. Opposition to the law during its formulation resulted in several safeguards for employees’ rights and an orientation of privatised companies to the public good (see analysis). This has prompted some observers to refer to the new regulation as a quasi-privatisation law instead. Still, the new legislation is a shift in policy regarding the control of state assets, and it is likely to lead to new opportunities for private investors. Currently, the two most high-profile deals in process in light of the new regulation are the privatisation of the nation’s bourse and the national airline, Kuwait Airways.

PUBLIC FINANCE: Kuwait’s ability to implement such an ambitious development strategy is underwritten by its sizeable oil revenues. The nation has recorded budget surpluses for the past 13 years and is expected to continue doing so in the short to medium term. Revenue earnings for FY 2012/13 (with the fiscal year running from April 1 to March 31 of each year) are as buoyant as ever: total revenues climbed in the first 11 months of the year to KD18.8bn ($67.15bn) and the budget surplus for the year is set to be in the region of KD14bn-15bn ($50bn-53.6bn). Oil revenues rose by 9% year-on-year (y-o-y) to reach KD29.4bn ($105bn), while non-oil revenues climbed 12% y-o-y to KD1.6bn ($5.7bn). Not all of this revenue is deployed in shortterm fiscal commitments. Kuwait plans to utilise its fiscal power of today to benefit the future citizens through its Future Generations Fund (FGF), into which it has directed 10% of total state revenues since 1976. In 2012 the input rate was raised to 25%, a move welcomed by some observers as a sign that the government is adopting a longer-term fiscal strategy (see analysis).

Nevertheless, despite the nation’s robust revenue base and efforts to diversify its income, concerns remain regarding the structure of Kuwait’s fiscal policy. While capital spending has constituted around 11% of the budget for the past seven fiscal years, despite the NDP’s recently adopted capital-intensive projects, current expenditures on public sector wages and subsidies in areas ranging from electricity to basic foodstuffs have been steadily rising. In FY 2005/06, current expenditures stood at around KD6bn ($21.44bn), but by FY 2011/12 this figure had swelled to KD15bn ($53.6bn). While rising oil prices have allowed Kuwait to continue showing largesse to its citizens, such a high level of public spending makes the country vulnerable to external shocks and threatens to bring an end to the era of budget surpluses. “Both the IMF and the World Bank have warned Kuwait about spending and public salaries. If public spending rises continue in this way, we will see a budget deficit by 2020 or 2021. This is a risk in the long run,” Majdi Amin Gharzeddeene, senior vice-president and head of investment research at local investment firm KIPCO Asset Management Company, told OBG. According to the IMF, in the short to medium term Kuwait has sufficient fiscal space thanks to its years of budget surpluses and the buffer that its considerable foreign investments provide. However, while the fiscal break-even price per barrel of oil remains similar to historical levels, the IMF notes that the higher wage payments and government pension contributions would be difficult to reverse in the event of a decline in oil prices. Moreover, the IMF estimates that if current spending trends continue, the budget surplus from oil revenues will be exhausted by 2017 even without a significant deterioration of the oil price. This would mean that the government would be unable to set aside any portion of these revenues for the FGF. The fiscal challenge facing the government, therefore, is to reach fiscal consolidation through reduced public spending (or a reallocation towards capital spending) and revised subsidies or tax reform, while retaining the good will of a public that has grown used to government support.

External sector, 2010-13 Kuwait’s principal monetary policy goal, meanwhile, is the management of liquidity in the market. Its agency in this regard is limited by the fact that the Kuwaiti dinar is pegged to a basket of currencies, having abandoned the dollar peg in 2007 as a response to rising inflation. Other macro-prudential policies, therefore, have become all the more important as a means to manage liquidity and credit conditions, including tools like the loan-to-deposit ratio, liquidity ratio and household debt-service ratio. Kuwait has used these tools efficiently in recent years, and current liquidity conditions are considered supportive of private sector credit growth. Policy interest rates are expected to remain historically low, which the IMF attributes to Kuwait’s “high degree of free capital mobility, the currency basket peg and low international interest rates”. While public sector wage increases raise the possibility of higher inflation, consumer price index (CPI) figures showed that inflation slowed to 1.6% y-o-y in March 2013, with inflation estimates for the full year in the region of 3.5% or lower. As of June 2013, inflation stood at 3%.

OIL & GAS: Kuwait possesses the fifth-largest oil reserves in the world, standing at 101.5bn barrels at the end of 2011, and its successful utilisation of this resource represents the financial underpinning of its economy. Around 52% of Kuwait’s GDP is derived from the oil and gas sector, and its importance to the nation’s development is the principal reason the government retains complete control and ownership of all upstream activity, which it directs via the Supreme Petroleum Council (SPC). Kuwait’s oil wealth is spread across a number of onshore fields, the largest of which is the renowned Greater Burgan complex that alone has reserves in the region of 70bn barrels. Over the past decade, Kuwait has succeeded in increasing its oil production level from an average of 2.2m barrels per day (bpd) in 2001 to 2.8m bpd in 2012, and by 2020 it aims to increase its output to 4m bpd. Reaching this target will require tapping into old fields with new technology, as well as exploiting new fields, particularly those in the northern and western parts of the country, some of which were discovered as recently as 2006. The enhanced oil recovery (EOR) techniques that Kuwait is likely to apply to its new fields have led to speculation that it may allow a greater participation by international oil companies (IOCs), which are currently prohibited from entering into production-sharing agreements by an article in the constitution. Kuwait has launched a number of initiatives in the past aimed at encouraging foreign participation without violating the constitution, including incentivised buy-back contracts and enhanced technical service agreements, and majors such as Royal Dutch Shell have established fruitful relationships with the country (see Energy chapter).

In 2006 Kuwait made its first discoveries of nonassociated natural gas, and by 2009 the new resource was already under production. In 2011, gas reserves stood at 63trn cu ft, while production levels were 57m cu ft per day. Gas now plays a key role in a range of activities, most notably electricity generation, water desalination, petrochemicals and as an agent in EOR processes. Current plans would see total gas production rise to 4bn cu ft per day by 2030, including 1.5bn cu ft of gas not tied to oilfield output.

More opportunities for private sector and foreign participation exist in the downstream segment. Kuwait currently has three crude refineries with a combined capacity of 936,000 bpd, but a new clean fuels project will see two of them upgraded, one closed down and a new 615,000-bpd refinery built at Az Zour which, when completed in 2018, will be the largest in the region. The SPC gave approval for the KD4bn ($14.3bn) project in June 2011 following three years of political deadlock. In December 2012 global engineering and project management company AMEC was awarded the $528m project management consultancy contract.

FINANCE: In 2011 the non-oil sectors accounted for around 38% of GDP, according to Central Bank of Kuwait data. Following the government’s social services expenditure, financial institutions represent the largest nonoil GDP component, accounting for 9.5% of the total in 2010. Kuwait’s banks have come through a difficult period of falling asset values and non-performing loans in the wake of the global economic crisis to return to profitability. Their resilience was demonstrated in 2010 when the nine listed Kuwaiti banks showed an impressive return to profitability, reporting a 61.7% y-o-y rise in net profits to reach KD575.4m ($2.05bn). Since then, bank liquidity has improved substantially as a result of high retail deposit growth and still-moderate lending growth, while non-performing loan (NPL) ratios have Private sector investments abroad, end-2011 declined steadily – from 11.5% in 2009 to 7.3% in 2011. According to the IMF, the banks’ capital adequacy and leverage ratios remain “robust”. With the sector stabilised optimism regarding its future growth stems from its anticipated role in financing the many construction and development projects prescribed by the NDP. For now, however, profit growth remains modest: the aggregated growth in net profits of Kuwaiti banks did not exceed 1.2% in 2012. This, in part, reflects the more cautious strategies they have adopted, which has resulted in a more restrictive financing environment. Even so, private sector lending has increased modestly over recent years, climbing from KD27bn ($96.4bn) in 2009 to KD28.2 ($100.7bn) in 2012 and 2013.

Kuwait’s investment companies (ICs) have shown a less sure-footed recovery. Their exposure to domestic, regional and international real estate markets made them vulnerable to the global downturn, and the reemergence of global liquidity constrictions in 2011 slowed their recovery. Several ICs were delisted from the exchange in 2012, while more were given final warnings to tackle their financial situation.

STOCK EXCHAGNGE: The Kuwait Stock Exchange (KSE) is the oldest in the region, and as of July 2013 had 195 listed companies across a range of economic sectors, with the largest indexes being financial services (53 listings), real estate (38) and industry (39). The market is currently undergoing a period of transformation. A long-awaited Capital Markets Authority (CMA) came into being in 2011 with a mandate to grow the exchange after a period of lacklustre expansion and market volatility that followed the global economic crisis. The CMA is working with the central bank and the KSE management to develop the exchange’s regulatory environment and increase its viability as a source of funding. Their efforts in this regard have intensified following an announcement in January 2012 that the KSE will be privatised in a process overseen by global financial firm HSBC. To boost the exchange’s attractiveness to potential investors, the CMA and KSE have introduced a number of technological and regulatory improvements: the new NASDAQ QMX trading system was implemented in May 2012; a new website launched shortly after; sector classifications were reworked according to the industry classification benchmark standard; the new Kuwait 15 index was added; and a stricter approach was taken towards reporting and transparency requirements. The KSE’s performance in 2012 reflected the significant reform process it is undergoing, gaining 2% over the year. However, the longer-term prospects of the newly configured KSE are encouraging. During the first half of 2013 the exchange registered a stronger performance than in recent years, with the index closing in June of the year at 7772, slightly down on May but some of the strongest results since early 2010.

TRANSPORT & COMMUNICATIONS: The transport, communications and storage sector is the secondlargest non-oil contributor to GDP, accounting for 8.4% of the total. This figure includes the activities of Kuwait’s two container ports, Shuwaikh and Shuaiba, and the smaller Doha port, which have a combined capacity of 1.2m twenty-foot equivalent units per annum; two commercial air carriers, the flag carrier Kuwait Airways and Jazeera Airways; three mobile operators, Zain, Wataniya and Viva; four major internet service providers (ISPs); and around 50 sub-ISPs that purchase bandwidth from the major players and sell it via pre-paid cards.

The communications segment is one of the most open in the private sector, with the government only retaining control of the fixed line segment and the international gateway. Under the NDP a number of information policies are geared toward strengthening the sector’s role in the economy, including upgrading the national infrastructure with a new fibre-optic network; further liberalisation of the sector through the privatisation of some services, such as fixed telephones; upgrading the skills of workers in the field of information technology (IT); and disseminating information regarding IT and its applications to the community.

MANUFACTURING: Accounting for about 5.1% of GDP, manufacturing is a sizable sector in Kuwait, with a significant downstream petrochemicals industry largely controlled by the state-owned Petrochemicals Industry Company (PIC). The sector has also seen considerable private sector involvement. For example, PIC owns 42.5% of the polyethylene and ethylene glycol producer Equate Petrochemical Company, along with Dow Chemical Company (42.5%) and local private player Boubyan Petrochemical Company (9%), an entity that was created and sold off by PIC.

As part of the NDP, the government intends to build up its manufacturing base across a spectrum of nonpetrochemicals industries currently characterised by small and medium-sized businesses of between 10 and 50 employees. These include manufacturers of processed food products (including dairies, bakeries, fruit juice production, confectionaries, and vegetable and fish processing), semi-processed food products (such as beverage bases, dried pulses, and food ingredients for the snack and bakery segment), textiles, paper, detergents, durable household goods, construction materials, furniture, décor and electrical goods, and a small metals industry, among others.

TRADE: Thanks to its petroleum exports, Kuwait has enjoyed years of favourable trade balances. In 2012 the trade surplus reached an all-time high of KD25.9bn ($92.5bn), surpassing the previous year’s total, also a record, of KD21.2bn ($75.7bn). Oil exports for the year stood at KD31.6bn ($112.9bn), an 18% rise on 2011 driven by greater oil production and a 3% y-o-y increase in Kuwait Export Crude prices to $109 per barrel. Nonoil exports also posted growth, rising 5% y-o-y to KD1.6bn ($5.7bn). While a looser global oil market is set to result in a slowdown in oil export growth in 2013, Kuwait’s record of consecutive trade surpluses will remain a feature of the economy into the long term.

The nation has signed a number of trade agreements in recent years aimed at strengthening its performance further. At the regional level, Kuwait is party to the free trade agreement (FTA) between Singapore and the GCC signed in 2008. The GCC has also successfully concluded an FTA with the European Free Trade Association (EFTA), which includes Iceland, Liechtenstein, Norway and Switzerland. Kuwait has also signed bilateral agreements with nearly 50 countries, which include China, Germany, France, India, Italy, Korea, Malaysia, Pakistan, Russia, Spain, Turkey and the UAE. In 2004 Kuwait signed a trade and investment framework agreement with the US, which is considered a first step in developing a more liberalised trading relationship and has created a forum in which technical issues such as intellectual property rights, taxation and investment requirements can be addressed.

TAX: The overall tax burden in Kuwait is light, and recent changes reveal willingness by the government to lower rates in order to attract investment. Taxation is governed by the Tax Decree of 1955 as amended by an executive bylaw in 2008, as well as a number of treaties with foreign nations. There is no personal income tax in Kuwait. Taxes on corporations common in other jurisdictions, such as capital duty, payroll tax and real property tax, are also not applied. Locally incorporated firms that are wholly owned by Kuwaiti or GCC nationals are entirely exempt from income tax, although 2.5% National Labour Support Tax on annual profits is applied to companies listed on the KSE.

Foreign companies can undertake business in Kuwait through an agent, as part of a joint venture or as a minority shareholder in a locally registered company. A flat tax rate of 15% is levied on the foreign company’s share of the profit, plus other amounts receivable, such as interest, royalties and commissions. The current rate has been in place since 2007 and replaces a variable rate that could reach 55% in some instances. Finally, social security is payable by both employer and employee at a rate of 11% and 7% of salary, respectively.

Kuwait has a number of tax incentives, most of which target foreign investment. The Direct Foreign Capital Investment Law of 2001 grants a tax holiday of up to 10 years for qualifying projects, as well as an additional tax waiver for a similar period on further investment in an already existing project. The new FDI law, passed by the National Assembly in 2013, upholds these concessions. The non-Kuwaiti founders and shareholders of leasing and investment companies that have their principal place of business in Kuwait are entitled to a five-year tax holiday, while businesses set up in the Kuwait free trade zone, where foreign entities can own 100% of an enterprise, are exempt from taxes on specified operations. Kuwait has also signed tax treaties with more than 30 countries to avoid double taxation, including with the UK, France, Germany, Russia and Turkey. Spain and Japan were added to this list in 2012, with the respective agreements ratified by parliament in 2013, and securing more reciprocal agreements remains a priority for the Ministry of Finance. Kuwait is also a signatory to the Arab Tax Treaty and the GCC Joint Agreement, which prevents double taxation on most economic activities. Looking ahead, Kuwait is curEconomic indicators, 2011-15 rently working with the World Bank on an assessment of its current tax system. While no major alterations to the corporate tax regime are anticipated in the short term, the government is studying the design, formulation implementation of a value-added tax (VAT) law.

CHALLENGES: A lack of investment in infrastructure since the 1980s and an annual increase in energy demand of approximately 7% have made the provision of electricity a central concern for the government over recent years. After almost falling through its reserve margin in 2009, the government has succeeded in increasing generating capacity to over 14 GW, against a projected peak demand of 12.4 GW by August 2013. However, this has necessitated the import of liquefied natural gas (LNG) at a cost of KD400m ($1.4bn) per year, a practice that will remain a burden on the state budget until production of Kuwait’s sizeable gas reserves can be increased. Moreover, to keep pace with an anticipated rise in electricity demand of 6% per annum in the coming years, Kuwait’s pipeline of power projects will have to be developed on schedule. The question of access to electricity will thus remain of interest to investors, particularly those involved with large industrial and construction projects.

The power question feeds into Kuwait’s low ranking in terms of business competitiveness, in particular on issues such as government bureaucracy and restrictive labour conditions. The World Bank’s “2013 Doing Business Report” ranks Kuwait 82nd, five places lower than in 2012, although it does note that the country has taken steps to reduce the number of procedures required to get construction permits, register properties and access electricity. The IMF has also identified several corporate governance indicators, such as auditing quality, financial reporting, boards of directors’ efficacy and safeguarding minority shareholders’ interests, as areas where Kuwait would benefit from a regulatory or policy overhaul. Many of these issues are addressed by a new FDI law promulgated in 2013 (see analysis), which has established an independent investment promotion agency that will reduce the levels of bureaucracy faced by foreign investors, as well by as the actions of the CMA, which has been especially attentive to corporate governance issues since the 2012 announcement of KSE’s privatisation.

OUTLOOK: Despite these challenges, the economic outlook is positive in the short to medium term. Having raised oil production to 2.8m bpd in 2012 from the 2.5m bpd of 2011, and with oil prices in 2013 expected to remain around the $110 mark, continued budget surpluses are expected for FY 2013/14 and beyond. Spending on the NDP, meanwhile, underpins the continued expansion of the non-oil sector, where there is planned investment in infrastructure and industry, particularly downstream activities that can benefit from hydrocarbons wealth. There are also signs that the government is starting to deploy revenue more effectively: the IMF estimated that capital expenditure grew at 30% in 2012/13, compared to a 16% growth in the public wage bill. The key challenge will be to prevent the erosion of budget surpluses via fiscal consolidation.