ECONOMY: Defeating the deficit - no pain, no gain

24 February 1995

The halcyon days of the oil boom years are a distant memory. Lower oil prices are forcing oil producing countries to review the way they run their economies and Kuwait is no exception. In addition, it has to come to terms with the fact that the country's budget deficit is not an aberration caused by war and reconstruction, but a structural feature of the economy. Cutting that deficit has become the priority, and a reduction in the state's dominant role in the economy is seen as the best way of achieving it. A privatisation programme is evolving. The welfare state is under scrutiny. Even taxation is on the cards. After years of debate there is a growing sense of urgency about the need for change and major policy changes are expected in the coming months.

'It is true that if the oil price increased by $3 a barrel, the budget deficit would disappear,' says Ali Rashid al-Badr, managing director of the Kuwait Investment Authority (KIA), 'but we cannot take this as read. During the remainder of the decade we must diversify and give the private sector a bigger role in the local economy. The Kuwaiti economy was built by the private sector. It will again enjoy a role in the future.'

It is more than a year since Finance & Planning Minister Nasser al-Rodhan declared that budget reform was at the top of the government's agenda. As the budget planning advanced last December Al-Rodhan announced that the deficit would be cut by KD 250 million-300 million a year for the next five years to achieve a balanced budget by 2000.

Preliminary figures for the 1995/96 budget reveal an even more ambitious reduction. On 7 February, following cabinet approval of the budget draft, Al-Rodhan announced that the net deficit would be reduced by one third in the year to KD 1,088 million, compared with a projected KD 1,766 million in 1994/95. The reduction is to be achieved by a 14 per cent increase in oil revenue and a 25 per cent increase in non-oil revenue. Expenditure will be cut by KD 138 million but the only spending cut actually identified is a planned 5 per cent reduction in the project budget.

Just how the government will achieve its budget targets has not yet been revealed. As a 16 per cent overspend in the 1993/94 budget suggests, reining in government spending is easier said than done. Much of what needs to be done to end the distortion of the economy was set out in a World Bank report completed in October 1994. The report, commissioned at the request of the government, has not been made public but its recommendations are understood to embrace most of the issues that have been debated in Kuwait since the invasion. These are:

Cutting subsidies. The government spends KD 150 million a year subsidising 90 per cent of electricity costs and KD 125 million a year subsidising 75 per cent of water costs. Reducing subsidies on domestic utilities, petrol and telephone services is likely to be the government's first line of attack. There are obstacles to be overcome, however. Systems for managing billing do not exist. In addition: two thirds of the country's water meters are reported broken, entering homes to read meters would be opposed on privacy grounds and an alternative, centralised metering system for electricity would be time-consuming and expensive to install.

Reform of the welfare state. Kuwait has a lavish welfare state. Annual spending on healthcare is KD 200 million, of which KD 50 million goes on Kuwaitis who are referred abroad for treatment at the state's expense. Private health insurance is being considered, but not until Kuwaitis have adapted to the erosion of subsidies on utilities. The right to free housing is also targeted. For the time being the state is still heavily committed - building 5,000 homes a year for Kuwaiti citizens in suburban areas while thousands of apartments stand empty in Kuwait City.

Taxation. Direct taxation is still politically unacceptable. There are also practical problems. Privacy is paramount and no Kuwaiti would willingly disclose income from investments, making it virtually impossible to tax. Any direct taxes would have to levied on salaries rather than total income, exposing the system to the charge that it is unfair.

Indirect taxes are likely to come first. In January, the Finance & Planning Ministry proposed a sales tax on locally made goods at the same rate as customs duties. It also proposed increasing these duties to 10 per cent by 2000 from 4 per cent in 1995. Corporation tax is also envisaged. At present, companies wholly owned by Kuwaitis are exempt from the heavy taxes levied on foreign company profits and the profits of foreign shareholders in Kuwaiti companies. Foreign companies are liable to a top rate tax of 55 per cent applied to annual profits of over KD 375,000. The tax is also punitive. The entire profit is taxed at the same rate rather than being subject to a progressive rate.

Ending protectionism. Apart from some exemptions for GCC citizens, foreign nationals are barred from majority ownership in nearly all businesses, and cannot trade on the Kuwait Stock Exchange except through mutual funds. A law allowing foreign equity stakes of up to 40 per cent in the banking sector was introduced in August 1994. However, foreign banks are unlikely to be attracted unless they can have majority control, bankers say. Further liberalisation is not expected, at least until the difficult debts issue has been laid to rest.

Privatisation. This will be go ahead on two fronts: the sale of government shareholdings in local companies; and the privatisation of the telecommunications, power, and water industries and the sale of wholly state-owned companies such as Kuwait Airways Corporation.

The KIA, the government's investment arm, intends to sell all but 10 per cent of its KD 800 million worth of holdings in 62 local companies. The process has already begun, with the government's stake in 15 local companies already sold. These include Alahli Bank of Kuwait, United Real Estate Company, the Holiday Inn Crown Plaza, and Commercial Facilities Company (CFC). The sale by public subscription of more than 70 million CFC shares in September 1994 was an encouraging sign of investor enthusiasm in the local market. The offer was more than five times oversubscribed.

The privatisation process is due for completion within three years, with a sale every one to two months. There is no set timetable for the process, however. 'Much depends on the absorptive capacity of the local market.' says Elias Baroudi, chief economist of the National Bank of Kuwait, 'These things have to be done on a piecemeal basis so as not to overburden the market.' Next in line for sale is KIA's stake in the Kuwait Investment Projects Company (Kipco). A date for sale of the company by auction is expected soon.

The privatisation of state utilities is a far greater challenge. Major changes to place them on a commercial footing would have to precede the sale of the electricity, water and telecommunications services. An increase in customer charges is anticipated and Kuwaitis, once guaranteed employment for life, would face job losses too. The semi-private Mobile Telecommunications Company, formerly controlled by the Communications Ministry, is a telling example of what lies in store.Only 40 per cent of the staff were retained when the company was given the mandate to operate independently; the remainder were absorbed by the Communications Ministry. As state concerns are privatised, this option of redistributing labour to other government agencies will be closed off.

Plans for the privatisation of telecoms are the most advanced. A new company, Kuwait Telecommunications Company, is under formation, as the vehicle for the telecoms sale. Valued at KD 150 million, 52 per cent of its shares are expected to be sold by the end of the year.

Bureaucratic reform. The problem of employment is a major obstacle to be overcome. Around 90 per cent of Kuwaitis are employed in the public sector, largely in managerial positions, costing the government more than KD 2,000 million a year in public sector salaries. Small-scale studies are under way throughout the public sector to rationalise the bureaucracy, but reducing the bill involves a fundamental change in employment culture. Kuwait's growing population of nationals needing a job means that, on current trends, the wage bill will have doubled by the end of the century. A radical rethink of what work Kuwaitis can do themselves will be needed so that reliance on expatriates can be reduced and nationals trained to replace them.

Reform of the local financial sector. This is seen as an essential component of wider economic reforms. 'Restructuring the local banking and financial sector will enable it to perform its role efficiently and effectively,' says Sheikh Salem Abdel Aziz al-Sabah, governor of the Central Bank of Kuwait. 'Its objectives will be achieved through creating larger and stronger units capable of improving their assets and strengthening their financial positions.'

The first stage of the restructuring process has been the difficult debts law. Says Sheikh Salem: 'Operating profits made by most banking and financial units since then reflect a considerable improvement in their performance even when compared to pre-invasion levels.'

However, further reform is needed. 'Although all local banks are now turning profits from operating a reduced network of local branches, most of them are faced with other challenges - introducing advanced technology to their operations, satisfying increasing customer requirements and cutting down their total costs. Consolidating the banking and financial sector via mergers provides a means for tackling these challenges,' he says.


The passing of Law 51 of August 1994 allowing foreign participation is an indication that the sector has recovered, but further restructuring is necessary before this participation is extended, Sheikh Salem says. 'In future, once our banks and financial institutions are larger and capable of competing internationally, greater participation in the local banking sector may be allowed and foreign banks may be permitted to operate,' he says. 'But, there are no further plans at this stage for liberalisation. This will depend on the success of the restructuring of the sector.'

Kuwaitis urge a sense of proportion when considering the deficit issue. Balancing the books is pressing and necessary, but Kuwait is still a wealthy country. 'The Kuwaiti economy is basically sound, given the mineral reserves we have,' says Al-Badr. 'Let's not forget: In the long term, we are sitting on 10 per cent of the world's oil reserves with a population of only 800,000.' At $23,350, Kuwait has one of the highest per capita gross national product (GNP) figures in the world, lying just behind Germany and the US.

The government has so far been able to finance the deficit without recourse to international borrowing, and the country's reserves stand at KD 11,000 million, despite the ravages of the Gulf war. It has been a lack of political will which has so far prevented good intentions from being translated into action. The U-turn on the imposition of compulsory income tax in October shows that the government is sensitive to public opinion. However, even critics of the government detect a new earnestness in the attitude towards economic reform. The next few months will show whether the government now has the confidence to put the good intentions into practice.

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