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Fri 27 Feb 2009 04:00 AM

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Emirate on the edge

Kuwait's government is under pressure to reinforce the nation's financial sector and stabilise its political system.

Kuwait's government is under pressure to diversify away from oil revenues, reinforce the nation's financial sector and stabilise its political system, in a bid to pull the country back from the brink of recession.

Lower oil prices and an expected cut in government spending are threatening to push Kuwait into recession. The Gulf Arab state's economic woes are mounting fast, a result of the limited steps taken in recent years to diversify away from oil, a financial sector that looks increasingly fragile, and a turbulent political system that only exacerbates Kuwait's economic malaise.

"I expect to see a recession in Kuwait during the first half of the year," says Marios Maratheftis, regional head of research at Standard Chartered bank. "I do not expect to see any growth for the full year in Kuwait."

There is a need to diversify away from oil and to strengthen the private sector.

Kuwait's budget for the fiscal year 2009 to 2010 has yet to be announced, but finance minister Mustafa Al Shimali has indicated that the country will reduce spending due to the global economic downturn. As a result, Standard Chartered's growth forecast for the full year in Kuwait is zero percent; its lowest projected growth rate for any country in the region.

"This is not the right time to be reducing spending," warns Maratheftis. "It just pushes the country's economy further down into a recession."

Others, meanwhile, warn of an even deeper, more prolonged downturn. The National Bank of Kuwait (NBK) has one of the bleakest forecasts for the Kuwaiti economy, predicting a four percent contraction in real economic growth in 2009. Egyptian bank EFG-Hermes has predicted that economic growth will contract 1.2 percent in 2009.

According to analysts, Kuwait's main disadvantage in the current environment is its heavy dependence on oil. The sector accounted for 57 percent of GDP in 2007.

"One of the reasons we are concerned is Kuwait did very little to diversify its economy," Maratheftis says.

Certainly, oil has served the country well in the past, with the Gulf state reaping the benefits of climbing oil prices in recent years, allowing Kuwait to enjoy healthy economic growth as income from the commodity poured in. But the tide has turned, with oil prices having slumped more than $100 since a July 2008 peak of $147 a barrel, and the change in fortune is likely to hit Kuwait hard.

"It has been a point of discussion in Kuwait that there is the need to diversify away from oil and to strengthen the private sector," says Elias Bikhazi, research director at NBK. "When things get bad, I think maybe everybody remembers that we need to do something about that."

But for now, the problem is that there is little the emirate can do to halt plummeting oil revenues.

"Oil prices are determined internationally and production is determined with OPEC, so the government doesn't have a whole lot of leverage on the oil side of things," Bikhazi notes.

Other Gulf states are far from immune to the downturn in oil prices, but the consensus is that Kuwait remains one of the most exposed. Indeed, government revenue from oil across the GCC is set to plunge from $460bn in 2008 to $257bn in 2009, according to the latest IMF forecasts.

However, there are other factors aside from slumping oil prices weighing on Kuwait's economic growth prospects.

According to a January report from NBK, non-oil GDP could also fall by around two percent, "unless the authorities act early enough to shore up the non-oil sector back into positive territory".

The financial sector, which is the second largest sector after hydrocarbons, looks particularly precarious. Global Investment House, Kuwait's biggest investment bank, announced in January that it had defaulted on most of its debt, and then in February revealed that it had sold its stake in Palestine Real Investment Co for $17.2m.

The state, meanwhile, has had to step in to prop up Gulf Bank after the commercial bank suffered huge losses from ill-fated derivatives investments. As calls for action mounted, the government last month announced a $5.4bn bailout package for Kuwait's banks, which is now awaiting parliamentary approval. The stimulus plan would include a guarantee on 50 percent of new loans made by banks this year, in a move to break the lending freeze.But concerns remain despite the plan, with some economists saying that the package is not enough. "Markets were anticipating a larger rescue plan," notes Maratheftis, echoing market sentiment.

Last month Standard & Poor's placed a string of commercial Kuwaiti banks on CreditWatch negative, suggesting they could be downgraded in future. The agency cited the banks' exposure to "distressed" local investment companies and consequent indirect exposure to slumping real estate and stocks.

"We believe that a large number of investment companies in Kuwait, largely active in the real estate and stock markets, are facing major liquidity, and perhaps solvency, problems and have started discussions with some of their creditors to restructure their debt obligations," S&P's explained, going on to acknowledge that a support package could have a "significant impact if approved and executed".

Even if oil falls down to an average of $40 per barrel it will probably mean a break-even growth rather than negative growth.

Furthermore, individual investor confidence has taken a severe blow after Kuwait's bourse fell nearly 40 percent in 2008, leading to public demonstrations.

Kuwait Investment Authority, the Gulf state's sovereign wealth fund, pumped funds into the ailing bourse in response, but investor confidence still remains low, while consumer and business confidence has also taken a knock.

Nevertheless, amid all the negativity there are still some economists who remain relatively optimistic about Kuwait's future economic growth prospects.

"I think recessionary fears are a bit excessive at the moment actually," says Mandagolathur Raghu, head of research at Kuwait Financial Centre (Markaz), adding that he expects economic growth of 2.5 percent for Kuwait in 2009, based on an average oil price of around $55 per barrel.

"Even if oil falls to an average of $40 per barrel it will probably mean a break-even growth rather than negative growth," he continues, pointing out that even economic growth of 2.5 percent in 2009 represents a steep fall when compared to growth of 5.4 percent in 2008.

Raghu also concedes that a government spending cut may severely dent economic growth in Kuwait. Other Gulf states, including Saudi Arabia, have pledged to increase fiscal spending and run themselves into deficits. Economists say that the Kuwaiti government has the ability to pull the country back from the brink of recession by following the lead of its GCC peers and opting for an expansionary budget. However, the state is expected to run a surplus as it holds back from raising its expenditure, even though it has the means to spend.

"That is definitely a concern in my view. This is something that might pull back growth, as strong spending at this stage would have definitely meant a lot for growth," says Raghu. He does, however, concede that a stimulus package "might compensate" for the cut in state spend.

Whether it will be enough to offset the damaging effects of the political impasse between Kuwait's government and its parliament, however, is another matter. So far, the problems have hindered reform and fuelled uncertainty, says Monika Malik, chief economist at EFG-Hermes.

"We believe there will be little structural reform in the economy in the short to medium term due to the continued clashes between the government and parliament," she warns. "Parliament will continue to question the new government on a number of issues and oppose the reform programme."

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