KUWAIT CITY, Sept 17: Kuwait’s non-oil economy has maintained a relatively healthy pace of growth even as oil prices remained more than half their levels of two year ago. Indeed, we see non-oil growth improving in 2016 and 2017, in contrast to cooling activity in some neighboring GCC countries.
The driver is a government-led development plan, which is helping ramp up both public and private investment, boosting the private sector’s share of the economy and addressing capacity constraints in a number of areas. The consumer sector is also expected to continue to support activity, though it is expected to see some healthy moderation.
It has been two years now since oil prices began to decline in mid-2014. As oil prices fell from over $100 per barrel, a sizeable fiscal surplus turned into a deficit. The government responded by proposing comprehensive economic reforms, including fiscal as well as structural reforms.
The government moved ahead with spending cuts targeting non-essential areas in FY15/16; more recently, it has introduced measures to reduce the subsidy bill. Initiatives to increase non-oil government revenues are also pending, including a value-added tax (VAT) and a corporate earnings tax, both of which require legislation.
The fiscal deficit is expected to narrow in 2017 as the price of oil gradually improves. We expect Brent to average around $45 a barrel in 2016 before rising to $55 in 2017. Fiscal reforms will also help close the gap. However, the risk that oil prices will under perform our projection remains a significant downside risk for the outlook. Weaker prices would put further pressure on the fiscal and external positions and could push the government toward more significant expenditure cuts and possibly even some reductions or delays in capital spending. However, we deem such a scenario unlikely.
Preliminary figures show overall GDP growth accelerating to 1.8% in 2015 from 0.5% in 2014, boosted by record high investment. While the figures show non-oil GDP growth slowing to 1.3% in 2015, we think growth will likely be revised higher when final figures are published. Data also show domestic demand growth improving in 2015, with stronger investment growth making up for some weakness in government and private consumption.
We estimate that non-oil GDP growth remained robust at 3.5% in 2015 and expect it to improve further to 4-4.5% in 2016 and 2017. In our view, the pace of growth has been improving as the implementation of the government’s capital projects picks up pace. Indeed, preliminary figures indicate that aggregate investment received a strong boost in 2015.
The improving pace of economic activity has been visible in private credit growth, which accelerated to 7.2% year-on-year (y/y) through May 2016. Credit growth has been particularly strong in the productive business sectors, with lending excluding personal facilities and lending to the financial and real estate sectors growing by 9.5% y/y, compared to growth of 6.1% y/y a year before. Credit growth is likely to end 2016 at an average pace of 7.5%, up from 6% in 2015.
Overall GDP growth should improve to 3.2% in 2016 and to 3.1% in 2017. In addition to accelerating non-oil activity, the gradually improving outlook is driven by a resumption of growth in the oil sector; we expect oil production to grow by around 2% in 2016 and 2017, following two years of contraction. This is mainly due to the gradual return of output from Wafra and Khafji, fields shared equally with Saudi Arabia in the Neutral Zone; production from these two fields, which amounts to around 250-300 thousand barrels a day of crude for Kuwait, was shuttered in 2014 and 2015.
The outlook for economic growth is driven largely by an improving pace of implementation of government-led infrastructure projects. The government’s development plan targets investment of KD 34 billion through 2020 and includes significant private investment. Among the projects are a number being implemented as public-private partnership projects (PPP), including the Al-Zour North power and water projects.
A clear pickup in the pace of project implementation has been visible since 2013. In 2014, more than KD 7.5 billion in projects was awarded with another KD 12 billion signed in 2015. Project awards in 2016 have kept up the pace, with KD 4.2 billion awarded through July 2016. Recent awards included the new airport terminal, which hopes to more than triple capacity by 2022 at an estimated cost of KD 1.3 billion.
The national accounts data also reflected the improvement in project implementation, with investment seeing a strong boost in 2015. Aggregate investment spending grew by 13% during the year, rising to 36% of non-oil GDP, a level that has not been recorded for over 20 years.
The consumer sector has long been a robust and reliable source of growth in Kuwait. This is expected to remain so in 2016 and 2017, though we see the sector moderating somewhat. The sector is supported by steady growth in employment and salaries, particularly in the government sector and among Kuwaiti households. Cuts in government wages and salaries are unlikely and subsidy reforms are expected to be gradual and thus to have a relatively limited impact.
Most consumer metrics continued to indicate a robust sector. Household income of civilian Kuwaiti employees remained resilient, growing by an estimated 4.4% y/y during the 12 months through March 2016. Household debt growth maintained a strong pace, standing at 11.3% y/y at the end of May 2016. This all supported continued strength in consumer spending, with credit and debit card point-of-sale outlays growing by 10.9% y/y in 1Q16.
Despite the relatively healthy consumer sector, confidence has revealed some signs of softness in the sector. The Ara Research & Consultancy consumer confidence index has retreated consistently over the last year. The 12-month average index reading was down by 5% y/y in July 2016. A weaker perception of current employment prospects weighed the most on the overall index. Expectations for durable goods purchases were also weaker compared to a year ago.
Since 2015, activity in the real estate market has been relatively weak. Real estate sales during the 12-months through July 2016 were off by 31% y/y. Most of the weakness was in the residential and investment sectors, with both sectors seeing 12-month trailing sales down by 37% y/y in July 2016. Commercial activity, which had seen sales down in 2015, has done better in 2016. Sales in that sector were up by 9.1% y/y through July.
The cooler real estate market has coincided with the decline in the price of oil and may reflect a more cautious investor. It has also coincided with a concerted effort by the government, since 2014, to increase the distribution of subsidized housing plots and built homes. The government nearly tripled its annual housing distributions to over 15,000 units in 2015 from around 5,000 the year before. In 2016, it plans to distribute more than 12,000. Expectations of an imminent increase in supply in the market may have helped cool market activity.
The drop in sales activity has helped precipitate an orderly correction in real estate prices. The sectoral price indices developed by NBK indicate that price growth has turned negative in the investment buildings and residential sectors. The 12-month trailing residential home price index was down by 7.6% y/y in August 2016 (preliminary estimate). In the investment sector, prices retreated by 5.1% y/y. (preliminary estimate) Meanwhile, residential land prices, which had seen declines last year, are now back in positive territory; they recorded mild positive growth of 0.9% through mid-August.
Inflation eased over the last year or so, as most components saw inflationary pressures diminish. Headline inflation stood at 3.1% y/y in July 2016, compared to 3.6% a year before. Services excluding housing have been a main source of reduced inflationary pressures, with inflation in this segment declining to 1.6% y/y in May 2016 compared to 4% a year ago. Meanwhile, pressures from housing services have been on the rise, with prices there, mostly representing housing rents, rising by 7.3% y/y. Rent inflation should abate soon. We expect average inflation to be mostly steady in 2016 at around 3.4% before accelerating slightly to 4% in 2017 as a result of steps to cut energy and water subsidies.
Government finances are expected to maintain a deficit in the medium term, especially with the price of oil staying below Kuwait’s estimated breakeven price of around $60-65 per barrel. A deficit of 18% of GDP is likely in FY16/17, after the mandatory allocation to the Future Generations Fund (FGF). The deficit is seen narrowing to around 11% of GDP in FY17/18 as oil prices improve and further fiscal reforms begin to take effect.
The government responded to lower oil prices with a number of fiscal reforms. Starting in FY15/16, the government sought to rationalize expenditures, cutting them by 15%. Most cuts were in non-essential items that had little impact on the domestic economy. More than half of the savings was “automatic”, the result of a drop in the cost of fuel and electricity subsidies. The rest came from transfers to independent public agencies and authorities. Meanwhile, expenditures on wages and salaries continued to grow, albeit at a more moderate pace. Capital spending was also left untouched.
In March 2016, the government approved a reform plan, which included a number of fiscal reforms. The plan included planned cuts in energy and water subsidies, and the introduction of a corporate income tax and a value added tax (VAT). In April, the National Assembly (NA) approved increases in electricity tariffs to take effect gradually from May 2017. While the step was a historic move, the NA approved a watered down version of the proposed cuts which should still save the budget around 1.5% of GDP.
In August, the cabinet announced plans to reduce fuel subsidies, a move not requiring legislation. Gasoline prices are to be lifted at the start of September 2016 by 42-62% for the various octane grades. The most popular 95 octane fuel, accounting for 80% of consumption, will see the price rise to 105 fils, a 62% increase. The annual savings to the state will be around KD 160 million, or 0.5% of GDP.
The government is also looking to introduce new taxes to boost non-oil revenues, though not before 2019. The government has proposed a 10% corporate income tax on local and foreign companies. The new tax is expected to replace several existing levies on corporate earnings in a measure that will broaden the tax base. Authorities are also preparing to introduce a 5% VAT in conjunction with other GCC countries. Both measures will require legislation.
Kuwait’s deficits remain relatively manageable given the state’s substantial overseas financial assets and ample capacity to borrow. In FY15/16, the full KD 6 billion deficit was financed out of the General Reserve Fund (GRF). Kuwait’s sovereign wealth fund assets are thought to near 500% of GDP. The bulk of the assets are with the Future Generations Fund (FGF), though the GRF, whose holdings are mostly liquid, also holds substantial assets thought to be around KD 25-30 billion.
Despite Kuwait’s substantial sovereign wealth fund assets, the government will rely on debt issuance to finance the bulk of the deficit in FY16/17. We estimate the government will need to finance around KD 6 billion in FY16/17 after the mandatory payment into the FGF. According to the government, more than 80% of that will be financed with bonds and sukuk. It has indicated it will issue around KD 5 billion in domestic and international debt in FY16/17.
The MOF is set to issue around KD 2 billion in new domestic debt in FY16/17. Gross issuance of local currency bonds and Shariah-compliant tawarruq during the first five months of the fiscal year, through the end of August, amounted to KD 1.65 billion; as a result, the MOF raised KD 980 million in net new debt; the debt level rose to KD 2.6 billion or an estimated 7.6% of GDP. The issued paper varied in maturities between one and seven years. The MOF has been seeking to increase the average tenor of the debt; maturities of 2-10 years now account for 47% of outstanding MOF debt, up from 31% at the end of March 2016.
There are also preparations to tap the international debt market. The MOF has stated it plans to issue around $10 billion (KD 3 billion) in foreign currency debt in FY16/17. Such a step will allow Kuwait to capitalize on its solid credit rating (Moody’s: Aa2, S&P: AA, Fitch: AA) and low international rates. Reports indicate that $7.5 billion in conventional bonds could be issued in 4Q16, while a $2 billion issue of Islamic sukuk is slated for 1Q17. The latter awaits the adoption of a sukuk law, which is expected to be ready before the end of 2016.
International debt issuance will also help relieve the pressure on domestic liquidity. With the government running a deficit and the current account seeing its surplus narrow considerably, system liquidity has come under some pressure. Money supply (M2) growth slowed considerably since 2013, from 10% y/y to 3.4% y/y in 2014 and just 1.7% y/y in 2015. Still, liquidity levels remain relatively healthy. Money supply (M2) to non-oil GDP was estimated at 147% in May, which is just above the average recorded since the financial crisis.
Interest rates have moved up over the last year in the wake of a hike in the policy rate late in 2015. The Central Bank of Kuwait hiked its discount rate by 25 basis points in December 2015 to 2.25% immediately following the rate hike by the US Federal Reserve. The 3-month domestic interbank rate had risen to 1.75% shortly after the rate hike but retreated since to stabilize at 1.56% by August.
The Kuwaiti dinar (KD) retreated slightly thus far in 2016, following two years of moderate appreciation driven by a stronger US dollar. The dinar index, which reflects the trade-weighted value of the currency, declined by 1.6% year-to-date (ytd), after having registered gains of 2.9% in each of 2014 and 2015. The dinar, which is pegged to a basket of major currencies with the US dollar having the largest weight, was up by 0.5% ytd in July against the US currency.
Kuwaiti stocks continued to lag the region thus far in 2016, with the year looking to be the third consecutive lackluster year. The Kuwait Stock Exchange’s value-weighted index (IXW) recorded monthly declines in every month since April and was down by 8.7% ytd through August 2016. The MSCI total return index was down by 7.2% for the same period.