KUWAIT CITY, Dec 26: Economic activity is expected to improve in 2016 and 2017, boosted by an increase in public investment and steady growth in consumption. This is happening despite the large decline in oil prices seen since the middle of 2014, and which has put some pressure on the government’s fiscal position.
While the government has already taken some measures to rationalize current spending, some of which are incorporated in the current budget, the impact on the domestic economy is expected to be limited. We have revised our growth outlook slightly downwards, though we still see growth improving.
The pressure on the country’s fiscal and external positions remains contained and manageable. The fiscal deficit should not exceed 6.2% of GDP in FY15/16 and is seen narrowing to under 4% in the following two years. Thanks to large fiscal and external buffers, the government is expected to maintain a relatively supportive fiscal stance despite the decline in oil revenues. The sovereign wealth fund is estimated at over 400% of GDP ($550 billion).
The main downside risk to this outlook is if oil prices remain lower for longer or if they see further declines from current levels. Our baseline view is that Brent will gradually improve towards an average of $55 a barrel in 2016 and perhaps $60 in 2017. A weaker oil price scenario would put added pressure on the fiscal and external positions of Kuwait and could result in more significant expenditure cuts and possibly even some reductions or delays in capital spending. Nonetheless, we think this is a risk and not our baseline at this point.
Activity in the non-oil sector has remained resilient, with growth accelerating to 4% in 2015 in our view. We also see growth accelerating further towards 4.5-5% in 2016 and 2017. And, though the most recent available official data on nonoil GDP growth shows slower growth of 2.1% in 2014, we think this will be revised upwards towards 3-3.5%. In our view, the pace of growth started to show some pick up back in 2014, supported by accelerating project implementation and a robust consumer sector. This momentum is expected to have carried over into 2015.
While growth is expected to accelerate, there are signs that nonoil activity is cooler than it would have been, had oil prices remained above $100. Private credit growth eased to around 6% by the end of 2014 and is expected to remain relatively steady at that pace at the close of 2015. However, a large part of this slowdown in credit growth was due to a slowdown in lending to the real estate sector. Also, the credit figures have been dampened by a number of corporates resolving legacy debts predating the financial crisis.
The somewhat robust outlook for the nonoil sector is being driven in large part by the outlook for government capital spending. Plans involve spending around KD 34 billion between 2015 and 2020. Since late 2013, there has been a marked improvement in the implementation of the government development plan. The plan calls for both government and private investment in a host of large infrastructure projects (PPPs in some cases). Following some delay in prior years, we have seen a pickup in the pace of implementation. More than KD 7.5 billion in projects were awarded in 2014 and another KD 12 billion during 2015.
The consumer sector has been a solid source of growth in nonoil activity and is expected to remain so in 2016 and 2017. This is supported by steady growth in employment and salaries, particularly in the government sector and among Kuwaiti households. As a result, growth in consumer spending and household borrowing has been robust. With no expectations of cuts in government wages and salaries and with subsidy reforms expected to be delayed and gradual, we see support for this sector remaining strong.
A number of consumer indicators show that the sector remains relatively resilient. Estimates of household income growth based on data from the Public Institute for Social Security have shown resilience, growing by 4.4% y/y through June 2015. Data on consumer’s spending using credit and debit cards shows that growth has remained relatively robust, at 17.8% y/y in 3Q15. Household borrowing has also been healthy growing by 12.9% y/y in September 2015.
Nonetheless, there have been signs that consumers have not been unscathed by the current low oil price environment. Consumer confidence has taken a hit. The average ARA general consumer confidence index has retreated by around 3% between 2014 and 2015 year-to-date through October 2015. Most of this decline was in the durable goods component, which dropped by 11%. Indeed, car sales retreated significantly in 2015. Data on the number of car registrations through October 2015 show that new car sales have fallen by 13% y/y in 3Q15.
The real estate market cooled significantly in 2015 following a strong showing in 2014. Total sales during the first ten months of 2015 decreased by 29% compared to the previous year. Growth in 2014 had topped 21%. Sales activity in all sectors was down in 2015, including residential, investment and commercial.
The impact on prices has been mixed. According to NBK estimates, prices of investment buildings continue to see positive growth, though that pace has eased significantly from a 43% y/y in early 2014 to about 8% in 3Q2015. Meanwhile, prices of residential plots and homes are little changed or have retreated y/y.
Inflation picked up in 2015 on higher inflation in housing rent and food prices. Average (12-month) inflation reached 3.2% y/y in October 2015, up from 2.8% a year before. Most of the inflationary pressures have come from domestic sources, with our own estimate of core inflation (excluding food) showing a similar trend. Offsetting these pressures have been a stronger dinar and weak international inflation. We expect inflation to average around 3.4% by the end of 2015 and to cool off in 2016 and 2017 to around 3%.
With the Brent oil price likely to remain in the $40-50 range and to improve only gradually in the coming two years, Kuwait is expected to post moderate sized deficits at least through 2017. Substantial fiscal buffers, in the form of a sovereign wealth fund estimated at over 400% of GDP, should help Kuwait pull through relatively easily, without making deep spending cuts. While the government is expected to tap into its liquid assets to finance part of the deficit, debt issuance is also expected.
Even with the government already taking some measures to rationalize spending, revenues are expected to fall short to the tune of 6.2% of GDP in FY15/16. This could narrow to 3.8% of GDP in FY16/17 on some improvement in oil prices. In FY17/18, we expect oil prices to recover further towards $60, which should help narrow the deficit to around 3.6% of GDP.
The government’s first response to lower oil prices was to rationalize spending. This initiative started late in 2014 and was reflected in the FY15/16 budget. The latter sought to reduce government expenditures by 17%. Around half of these cuts came from the reduced cost of fuel subsidies due to lower oil prices and were little more than an accounting change; the rest came from cuts in non-essential spending and reducing inefficiencies and waste. Importantly, there were no reductions in wages and salaries or in capital expenditures.
In the medium term, the government is keen on tackling subsidy reform, starting with fuel subsidies, in an effort to further rationalize spending and reduce economic inefficiencies. Subsidies in Kuwait amount to 9% of GDP according to the IMF. The cabinet is expected to issue a petrol subsidy reform package in the coming months. This is expected to include a phase-out of subsidies on petrol in 2016. It is thought that this will include a cash transfer to low income Kuwaiti households. The cabinet will likely make a similar proposal for electricity and water subsidies sometime in 2016 but this will require legislative changes.
The parliament is also currently deliberating on an ambitious wage bill reform initiative, which could result in substantial savings for the government on its wage bill. The legislation aims to standardize pay across the public sector and to increase control over the government’s wage bill. It will also put limits on wage and salary growth in the public sector by streamlining the process of salary increases.
Beyond efforts to reduce spending, the government is taking some steps to address the long term sustainability challenges facing Kuwait by bolstering nonoil revenues. Steps include efforts to introduce a comprehensive corporate income tax at a proposed rate of 10%. This would replace existing taxes imposed on foreign corporates and a number of smaller levies on domestic companies. Another measure being proposed is a value added tax (VAT), which is being tackled in a coordinated fashion with other GCC countries. Neither of the two tax initiatives is expected to take effect before 2019 at the earliest.
We estimate that the government will require around KD 10-15 billion in deficit financing in the coming five years. The government has sufficient liquid funds to easily finance the deficits in the medium term without resorting to debt, including KD 34 billion in mostly liquid overseas assets in the General Reserve Fund (managed by KIA, the Kuwait Investment Authority). Nonetheless, the Ministry of Finance has indicated an intention to finance some of this requirement through bond issuance in an effort to reduce the burden on KIA assets, to take advantage of low interest rates and to deepen domestic capital markets.
With the government running a deficit and the current account seeing its surplus narrow considerably, there is a concern that system liquidity could be under pressure. Indeed, we have already seen a slowdown in M2 growth, which has fallen from around 8% in the middle of 2014 to 5.3% in September 2015. Still, levels of liquidity remain relatively healthy. For example, M2 to nonoil GDP stood at 138% in 3Q15, compared to an average of 140% since the financial crisis. However, banks have seen some tightening in liquidity, with interbank rate spreads to Libor starting to climb.
The Kuwaiti dinar (KWD) continued to appreciate in 2015, pulled up by a stronger US dollar; the currency rose by 2.7% in trade-weighted-terms through the end of November 2015 following an increase of 3.2% in 2014. The dinar, which is pegged to a basket of major currencies, with the US dollar having the largest weight, depreciated against the US currency by 3.9% year-to-date (ytd) through November 2015 following a similar decline in 2014.
Kuwait’s stock market retreated during 2015, as low oil prices continued to weigh on investor sentiment but also pulled down by a large correction in emerging market equities. Following an initial but short-lived recovery earlier in 2015, the Kuwait Stock Exchange’s value-weighted index (IXW) was down by 10.5% ytd through November. The MSCI total return index was down by 10.6% ytd.