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II Accumulation for Future Generations: Kuwait’s Economic Challenges

Author(s):
John Wilson, Susan Fennell, Nigel Chalk, Mohamed El-Erian, and Alexei Kireyev
Published Date:
April 1997
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Author(s)
Mohamed A. El-Erian

Kuwait is a rich country. It has large oil reserves and, owing to its prudent financial policies of the 1970s and 1980s, possesses considerable foreign assets. The economy has a tradition of low inflation, a stable currency, and a liberal external trade and payments system. The oil sector has been diversified in recent years, with an extensive and growing range of downstream activities in Kuwait and other countries.

These attributes are important as Kuwait continues to recover from the August 1990 Iraqi invasion that severely damaged the economy. In addition to widespread human suffering, basic infrastructure was destroyed, oil production capacity disrupted, and government and private sector assets misappropriated.

The Kuwaiti government moved quickly and effectively after the February 1991 liberation to rebuild infrastructure and restore oil production and exports. Having successfully completed the reconstruction and rehabilitation phase, the government has turned its attention to addressing structural weaknesses in the economy that were accentuated by the legacy of the Iraqi invasion:

• With the decline in investment income because of the drawdown in foreign assets to finance liberation and reconstruction, the Kuwaiti fiscal system lost its revenue stabilizer. This heightened the country’s vulnerability to unfavorable developments in international oil markets. At the same time, with larger current spending on account of wages and salaries and transfers, the expenditure structure became less flexible.

• The disruptions to financial assets and markets compounded the existing problem of nonperforming loans caused by the crisis of the informal stock market in the 1980s. The authorities face the challenge of decisively reducing moral hazard risk, thereby fully restoring the integrity of the financial markets and ameliorating the intermediation functions.

• The change in the composition of expatriate workers triggered a series of transitional challenges. These range from skill mismatching to larger foreign exchange outflows associated with a more transient expatriate population and a larger number of single workers. It has also focused greater attention on the development of the indigenous labor force. With a relatively young population, this challenge has been rendered more urgent by the need to find sustainable employment opportunities for the growing number of nationals joining the labor force.

To address these challenges, the government has formulated a comprehensive set of measures under the Five-Year Plan being considered by the National Assembly. Consistent with the approach adopted by the plan, this section seeks to shed light on the main structural challenges facing the Kuwaiti economy. It analyzes the structure of the economy on the eve of the Iraqi invasion and the subsequent changes in economic and financial conditions. It then discusses the evolution of the authorities’ policy response since liberation and the remaining challenges. Concluding remarks are contained in the final section.1

Kuwait’s Economy on the Eve of the Iraqi Invasion

Kuwait is a small economy with full capital mobility and an open trade regime. Prior to the Iraqi invasion, it was characterized by sustained economic growth, low inflation, and a steady increase in its holdings of foreign assets. While the economy remained dependent on oil, its vulnerability to unfavorable developments in international oil markets was reduced by the cushion provided by large and rising investment income receipts. With major infra-structure activities having been completed, diversification efforts resulted in a broader scope of down-stream energy activities—both domestically and abroad. However, the role of the private sector remained limited, and the labor market was highly dependent on expatriate workers.2 The financial system was yet to recover fully from the 1982 informal stock market (Souk Al-Manakh) crisis that left the financial system with a large volume of nonperforming assets.

Despite the fall in international oil prices from their 1979/80 peak, Kuwait registered budgetary and balance of payments surpluses throughout the 1980s. This allowed the country to continue to increase its foreign assets in the context of its much-respected tradition of building wealth for future generations. The sound financial balances contributed to steady economic growth (averaging 3 percent per annum in the 1980s) and low inflation (1.5 percent). Kuwait also maintained a very generous foreign aid program.3

In 1989, the year preceding the Iraqi invasion, Kuwait’s budget surplus was close to 30 percent of GDP, having recorded annual averages of 15 percent of GDP in the previous three years—this at a time when several other oil producing countries were experiencing deficits due to the oil price decline. With a large external current account surplus ($5.5 billion), it recorded an overall balance of payments surplus of $1.3 billion in 1989. Inflation was contained at about 3 percent, while the foreign aid program was maintained above the UN recommended level of 0.7 percent of GDP.

Oil played an important role in the Kuwaiti economy. Despite the limitation on output imposed by Kuwait’s adherence to the ceiling set by the Organization of Petroleum Exporting Countries (OPEC), oil accounted for about 40 percent of GDP4 and 90 percent of total exports of goods. However, the sensitivity of the economy to unfavorable fluctuations in international oil prices was reduced because of investment income. Reflecting the country’s large foreign assets, investment income amounted to 86 percent of oil export receipts in 1989. Its share of budgetary revenue was also significant, amounting to 35 percent in 1989/90. The resulting revenue stabilizer role insulated Kuwait to some extent from the impact of unfavorable fluctuations in international oil prices.

The Economic and Financial Impact of the Invasion

In addition to considerable human suffering, the Iraqi invasion inflicted widespread physical damage and resulted in large budgetary and balance of payments deficits, disrupted the domestic financial market, halted foreign trade, and paralyzed the labor market. Over 60 percent of the existing oil wells, the lifeline of the economy, were set on fire. In addition to shutting down production, this constituted a major environmental hazard for water sources, the air, and marine life. The oil sector suffered further on account of damage to drilling rigs, oil-gathering centers, refineries, and oil-loading and shipping facilities.5 While estimates of the total damage to oil facilities vary, the cost may well have been in excess of $10 billion.

The physical disruption spread well beyond the oil sector. Communication systems were dismantled and damaged. Private and public buildings were looted, and records and statistical systems lost. All electricity-generating plants were damaged. Production of goods and services came to a virtual standstill during the Iraqi occupation, with estimated GDP amounting to 10-20 percent of its preinvasion level.

The invasion’s immediate impact on Kuwait’s financial balances was substantial. As indicated in Figure 2.1, large budget and balance of payments deficits were recorded as a result of:

Figure 2.1.Selected Economic Indicators

Sources: Kuwaiti authorities; and IMF staff estimates.

• The sharp fall in oil output and exports.

• An erosion of investment income due to the significant drawdown in foreign assets.

• Large payments associated with Desert Shield and Desert Storm operations.

• The costs of restoring the country’s infrastructure after liberation.

• Higher government payments on account of wages and salaries and transfers.

Subsequent efforts to restore oil production and exports and contain expenditure led to a steady reduction in the twin deficits. However, Kuwait emerged from the crisis with a significantly weaker fiscal structure—an important determinant of future macroeconomic balances given the role that fiscal policy plays in this small, open economy. As illustrated in Figure 2.2 and detailed in Section III, investment income no longer acted as a strong revenue stabilizer—rendering the economy highly vulnerable to unfavorable developments in the oil market. On the expenditure side, outlays on wages and salaries and domestic transfers amounted to 27 percent of GDP in 1994/95, compared with 23 percent of GDP in 1989/90—which contributed to an upward shift in government spending and more limited flexibility.

Figure 2.2.Total Revenue and Investment Income

(In percent of total revenue)

Sources: Kuwaiti authorities; and IMF staff estimates.

The financial system, which was beginning to emerge from problems related to the Souk Al-Manakh collapse, also was dealt a severe blow as a result of the invasion (see Section VI). Financial contracts were severely disrupted, with assets serving as collateral destroyed. Certain of the banking system’s assets were looted, including the Central Bank of Kuwait’s gold holdings and unissued currency. The value of real estate and financial assets plummeted. Finally, while the damage to the financial databases was contained by timely steps to transfer the information abroad, there were some disruptions to records.

The Iraqi invasion and subsequent occupation led to a large-scale exodus of both Kuwaitis and expatriates. It is estimated that the population shrank to about one fifth of its preinvasion level. The contraction of the population had both supply and demand side factors. On the supply side, labor markets were disrupted by the absence of workers and the unavailability of certain skills. The resulting capacity constraints on the supply side were accompanied by a reduction in aggregate demand occasioned by lower consumption as a result of the fall in population. There were also some longer-lasting structural effects.

After liberation, there was a pronounced change in the composition of the expatriate labor force: a marked increase in the number of Asian single workers with short-term contracts and a decline in the number of skilled workers from the region who had previously worked under longer-term contracts and generally brought their families with them. The change in skill composition has put a premium on the development of the educated indigenous labor force. It has also contributed to a structural change in the current account of the balance of payments with larger outward workers’ remittances.

The Authorities’ Policy Response and the Challenges Ahead

Since liberation, the authorities’ response to the disruptions caused by the invasion may be divided into three phases:

• Immediate emergency operations to restore basic economic and social services for the population;

• Reconstruction and rehabilitation, with emphasis on the oil sector and infrastructure; and

• Addressing the remaining financial imbalances and structural weaknesses in the economy to reestablish sustained foreign asset accumulation, strengthen the financial system, and enhance the ability of the private sector to provide employment opportunities for the growing number of nationals entering the labor force.

Emergency Program, Reconstruction, and Rehabilitation

As a result of a rapid and effective response, the authorities were successful in quickly restoring basic economic and social services and infrastructure, as well as reviving oil activity. By June 1991, oil production and exports were resumed, although initially at very low levels. Domestic refineries began operating in August 1991. By November 1991, all oil well fires had been extinguished and the potential large-scale damage to oil reservoirs had been contained. By mid-1992, all existing wellheads had been either repaired or redrilled. The repair and recovery operations were completed much faster than scheduled, and crude oil production exceeded preinvasion levels by the end of 1992. Refinery capacity was fully reestablished in 1994.

Accordingly, by 1995, Kuwait’s oil production, capacity, and exports were above their preinvasion levels. Oil production amounted to 2 million barrels a day (mbd), consistent with Kuwait’s OPEC ceiling (Figure 2.3). Capacity amounted to 2.5 mbd, and steps were under way to increase it to 3 mbd by the year 2000. Domestic refinery capacity was increased to 0.8 mbd, with an expanding range of possibilities abroad.

Figure 2.3.Crude Oil Production

(In millions of barrels a day)

Sources: Kuwaiti authorities; and IMF staff estimates.

The restoration of the level of oil exports was reflected in the reemergence of a surplus on the external current account. It also contributed to the steady recovery of GDP. In 1992, GDP rose to the equivalent of 90 percent of 1989 GDP, and by 1993, had exceeded the 1989 level.

Restoring Financial Balances

The restoration of oil exports and the winding down of many postliberation exceptional outlays led to a steady decline in the budget deficit. By 1994/95, the budgetary deficit had been reduced to under 12 percent of GDP. In addition, the authorities began to repay the large bank syndicated loan of $5.5 billion contracted after liberation; the loan was fully repaid. Nevertheless, the budgetary position remained weak by Kuwait’s own historical standards as discussed in Section III. Moreover, with oil receipts accounting for 80 percent of revenues and a relatively inflexible expenditure structure, the economy remained highly sensitive to adverse developments in international oil markets.6

The authorities’ Five-Year Plan recognizes the need to reduce the fiscal deficit concurrent with a strengthening in the structure of the budget. As detailed in Section III, the plan targets budget balance by 1999/2000, a broadening of the revenue base, and a rationalization of expenditure. Key measures being proposed by the government include increases in custom duties from their current low levels and consistent with GCC harmonization efforts; a restructuring of the corporate income tax; higher fees and charges for goods and services provided by the state; and containment of expenditure.

The need for early movement in meeting the plan’s targets has been accentuated by Kuwait’s uncertain external outlook. Notwithstanding the increases in prices in 1996, most analysts anticipate relatively stagnant medium-term oil prices in real terms with significant downside risk. Accordingly, like other GCC countries, Kuwait cannot look to its external environment as a source of significant windfall revenues and stimulus for growth and reduction in financial imbalances.7 Domestic policies will need to play the main role.

Strengthening the Financial Markets

Following liberation, the authorities moved quickly to restore normal banking operations, and deposits rose rapidly to their preinvasion levels. Limits on deposit withdrawal, imposed to contain the immediate risk of capital outflows, were removed in August 1991, with all depositors, regardless of nationality, allowed to make withdrawals and transfer funds abroad if they wished. The currency reform implemented after liberation progressed smoothly, and the authorities succeeded in restoring and maintaining the preinvasion exchange rate arrangement.

Having overcome the risk of large-scale deposit withdrawals, the government moved to address the problem of nonperforming loans. As detailed in Section VI, initial steps included forgiving part of the outstanding consumer and housing loans, with lenders being compensated by the government. The government subsequently sought to arrange a debt workout for remaining claims, including claims out-standing from the Souk Al-Manakh episode. Effective implementation of the debt workout scheme was viewed as essential for reducing the risk of moral hazard, restoring effective payments discipline, and strengthening the integrity of the financial system.

The debt workout program has been accompanied by the strengthening of the prudential supervisory and regulatory regime. As discussed in Section V, the central bank has taken steps in recent years to strengthen capital adequacy standards, accounting procedures, and on-and off-site supervision. Also consistent with international guidelines, it has strengthened rules applicable to borrower exposure.

Progress in these various areas of money and banking policies contributed to a return of confidence in the domestic financial system. Interest rate differentials between financial instruments denominated in Kuwaiti dinars and U.S. dollars have narrowed sharply (Figure 2.4). Deposit holdings—in both domestic and foreign currency—have continued to increase, reinforced in 1995 by indications of capital repatriation by residents.8 Finally, the stock market has been very buoyant, registering in 1995 significant increases in trading volume and value (Figure 2.5).

Figure 2.4.Interest Rates

(In percent per annum)

Sources: Kuwaiti authorities; and International Monetary Fund, International Financial Statistics.

Figure 2.5.Value and Volume of Shares Traded on Kuwait Stock Exchange

Source: Kuwait Stock Exchange.

Improving the Functioning of the Labor Market

Kuwait’s labor market remains highly segmented. The public sector employs the bulk (over 90 percent) of the Kuwaiti labor force at salary and benefit packages that, on average, are significantly more generous than those offered by the private sector. The private sector is heavily dependent on expatriate workers.

Kuwait faces a potentially difficult labor market situation for two principal reasons. First, due to a relatively young population, a growing number of nationals will be entering the labor force. Second, and as detailed in Section IV, the needed fiscal retrenchment will, ceteris paribus, have direct and indirect contractionary impacts—directly by limiting the government’s ability to be the employer of first, as well as last, resort; indirectly, through the contractionary impact on private sector non-oil activity.

While there are a range of approaches available to the authorities to meet this challenge, two appear particularly relevant:9

• Improving the functioning of the labor markets, particularly reducing its segmented nature and structural rigidities; and

• Enhancing the willingness and ability of the private sector to provide sustainable employment opportunities.

The needed reform of public finances is inconsistent with the public sector retaining its function as the employer of first resort for Kuwaitis entering the labor force. The change in implicit and explicit entitlements to public sector employment will need to be accompanied by a more active role by the private sector in job creation. In addition to more buoyant non-oil activities, this will require steps to remove the distortions that currently bias incentives in favor of public sector employment, including containing the public sector wage bill and equalizing benefits between the public and private sectors. These actions will reinforce efforts being made at enhancing human capital development through improvements in education and specialized training.

Actions to improve the pricing of labor services and the productivity of the labor force will have a significant impact in the context of growing and dynamic private sector activities. Particular emphasis is being placed on deregulation, liberalization, and privatization.10 Appropriately, what is being sought is a transfer of responsibilities from the public sector to the private sector and a reduction in the barriers to private sector investment, be it from local or foreign sources. Efforts to widen and deepen money and capital markets will have a direct impact in this regard as will the rationalization of the subsidy and transfer system, as well as action to rationalize the very extensive incentive system.11 Fortunately, all these efforts are consistent with, and will reinforce, efforts being directed at reducing Kuwait’s financial imbalances, as discussed earlier.

Conclusions

Kuwait’s recovery from the devastating effects of the Iraqi invasion has been impressive. The rapid restoration of basic economic and social services has been followed by the recovery of the oil sector and the rehabilitation of infrastructure. Fiscal and balance of payments deficits have been steadily reduced, and the external debt incurred after the invasion has been settled.

Success in addressing the immediate negative economic and financial consequences of the invasion places Kuwait in a favorable position to address the remaining challenges. Chief among these are firmly establishing the country’s well-respected tradition of saving for future generations; providing employment for the growing number of nationals entering the labor force; and restoring fully the integrity of the financial sector.

The challenges facing the Kuwaiti economy are well recognized by the authorities as reflected, inter alia, in the new Five-Year Plan (particularly the deficit reduction plan), the implementation of the Debt Collection Program, and the central bank’s on-going strengthening of the prudential regulatory and supervisory regime. Determined implementation of the proposed adjustment and reform holds the promise of contributing to a virtuous economic and financial cycle in Kuwait.

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1See Sassanpour (1996) for a discussion of the policy challenges facing the six countries of the Cooperation Council of the Arab States of the Gulf (GCC) consisting of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. More general reviews of the economic and financial situation of countries of the Middle East and North Africa are contained in El-Erian and others (1996) and World Bank (1995a).
2Prior to the Iraqi invasion, foreign workers accounted for about 85 percent of the total labor force of about 900,000.
4Fifty percent if refining and petrochemical activities are included.
5Detailed information is contained in Tétreault (1995).
6This vulnerability is accentuated by the significant fluctuations in Kuwait’s terms of trade. At 1995 production levels, a $1 change in the price per barrel translates, ceteris paribus, into a $0.7 billion change in annual export receipts.
8Al-Loughani and Moosa (1993) contain empirical estimates of the demand for deposits in domestic and foreign currencies.
9For an earlier simulation exercise in this area, see Al-Ebraheem and Serageldin (1993). Information is also contained in World Bank (1995b).
10The Privatization Bill currently before the National Assembly covers the regulatory framework necessary for the next step of the privatization program.
11See Hoque (1995) for a list of industrial, tariff, financial, labor, tax, and investment incentives in Kuwait.

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