Kuwait’s successful emergence from one of the most turbulent periods in its history gives it a lot to be proud of.

Over the past three decades, events in the state, one of the smallest in the world, spanning an area of 17,818 square kilometres with a population of 3.6 million, have been dominated by factors beyond its control, which have had an impact on its social, political and economic life.

Between 1980 and 1988, Kuwait had to exist alongside two warring neighbours: Iran and Iraq. Not long after this conflict was resolved, in 1990, Iraqi President Saddam Hussein sent his army into the country, the culmination of deteriorating relations on economic affairs, including Kuwait’s refusal to waive Iraqi war debts and disputes over the state’s oil production.

By the time the invading forces were driven out by a US-led international coalition in 1991, the retreating Iraqi army had torched more than 700 of Kuwait’s oil wells.

Economic recovery

In 1991, Kuwait’s oil production fell to 191,000 barrels a day (b/d), from 1.9 million b/d in 1989, and its infrastructure reconstruction programme was hampered by low oil prices throughout the decade.

Having enjoyed a current account surplus of almost $10bn in 1989, in 1991 it had a deficit of $26bn, and by early 1992 it had amassed external debts of more $70bn.

This was up from just $8bn before the first Gulf war, which is said to have left Kuwait with losses totalling hundreds of billions of dollars.

These setbacks left Kuwait struggling to keep up with its Gulf rivals. “Twenty years ago, people said Kuwait was light years ahead,” says David Pfeiffer, managing partner of the Kuwait office of London-headquartered law firm Denton Wilde Sapte.

“But following the ravages of the Gulf war, it was natural that there was apprehensiveness about the future. No fly zones [which were in place until 2003] might prevent incursions, but the fact they were there spoke volumes for Kuwait as an investment location.

“Together with 55 per cent corporate tax rates and simple things such as higher insurance rates on shipping though the Strait of Hormuz, it did not look attractive to either regional or foreign investors.”

In recent years, the economy has recovered dramatically. In 2007, Kuwait posted a budget surplus of $43bn, taking its accumulated surpluses over the past nine years to almost $116bn.

Its 2009-14 economic strategy includes plans to spend $105bn to turn the state into a financial services hub. These plans were published in April 2008 and are expected to be approved in the current parliamentary session.

State oil company Kuwait Petroleum Corporation aims to invest $75bn in oil and gas infrastructure over the next five years, and there are plans for a series of major real estate and tourism projects including Failaka island, the Bubiyan causeway and the Madinat al-Hareer (City of Silk), north of Kuwait city.

However, whether these plans will be realised is likely to be determined by political rather than economic considerations.

Economic development in Kuwait is more closely linked to politics than in any of its Gulf neighbours.

The state is ruled as a constitutional monarchy based on the hereditary rule of the Al-Sabah family, with the oldest, and arguably the most developed, parliament in the Gulf .

Political will

Any nomination of a new emir or crown prince has to be approved by the National Assembly (parliament), and any amendments to the constitution have to be ratified by a two-thirds majority of its members.

In May 2005, women were given the vote, and the first female cabinet minister was appointed the same year.

Under this parliamentary system, Kuwait tolerates a freedom of debate that would be unthinkable in most Gulf states. Its media is also comparatively open.

In a 2007 report by Reporters Without Borders, a French non-governmental organisation that assesses press freedom around the world, Kuwait is ranked as having the highest level of press freedom of any Arab country in the Middle East.

Underlying expansive fiscal policy in recent years is an unwritten social contract under which the rule of the Al-Sabah family is tolerated in return for the population receiving a share of the country’s oil wealth. Examples of government generosity include writing off consumer debts for electricity and granting housing loans on preferential terms.

Kuwait’s political openness puts the executive branch of government under intense pressure.

At regular intervals, the National Assembly calls for government ministers to come before it to justify their policy decisions, which has led to some high-profile resignations.

Former oil minister Bader al-Humaidi resigned in November 2007 after only a week in office to pre-empt calls for a parliamentary probe.

In recent weeks, the dramatic downturn in the Kuwait Stock Exchange (KSE) has brought calls for the resignation of Saleh al-Falah, its director general.

Exhaustive parliamentary scrutiny of government means that implementing policy often becomes a drawn-out process.

The government has ambitious plans to develop its downstream oil industry, but the selection of contractors for the construction of an $18bn refinery at Al-Zour is being disputed by parliament and further setbacks to the much-delayed project are expected as a result (see Special Report, page 53).

Parliamentary opposition is also a factor in slowing proposed improvements to Kuwait’s business environment.

The 2008 Index of Economic Freedom produced by the US’ Heritage Foundation ranks Kuwait 39th in the world and second in the Middle East.

But the country is still widely considered to be behind its GCC peers in terms of progress on economic reform.

Foreign investment

Foreign companies operating in the country have to meet stringent conditions, including having a local agent, making contributions to the local economy through an offset scheme, and employing local workers.

Foreign stakes in local joint ventures are rare, wholly owned international companies operating in Kuwait are unheard of, and foreigners are prohibited from owning property in the country.

“The decision to liberalise effectively has to be a consensus,” says Pfeiffer. “And for a country with such a long history, it has to be done in baby steps.”

Many see the deregulation of Dubai’s business environment in 2004 and Kuwait’s failure to follow suit as a missed opportunity to increase inward investment.

According to the World Investment Report, published by the UN Conference on Trade & Development in late September, Kuwait was 134th in the world for attracting foreign direct investment (FDI) in 2007, despite its FDI potential being rated as 29th in the world the previous year.

FDI in 2007 amounted to $123m, lower than any country in the Middle East and North Africa region barring the Palestinian territories, and barely a tenth of the $1.14bn attracted by Qatar, the next-worst performer in the GCC.

As admirable as Kuwait’s political tolerance is, it would be a shame if its economic development were held back as a result.

Kuwait has an urgent need to diversify - oil accounts for 82 per cent of projected revenues in Kuwait’s 2008-09 approved budget.

But parliament’s reluctance to sanction substantial foreign involvement in the economy is holding up the government’s liberalisation programme.

“As long as the situation remains like this, hopes for reform - and the government’s ability to implement its economic programme - are growing thin,” says Randa Azar-Khoury, group chief economist at National Bank of Kuwait.

Project Kuwait, a government scheme to increase oil production by allowing greater participation of international oil companies, is seen as a test case in the administration’s programme to open up to foreign investment.

“The northern oil field project is about more than just developing fields,” says Pfeiffer. “It is the first huge step towards liberalisation in Kuwait.”

The scheme, first introduced in 1997, is still being held up by constitutional objections in the National Assembly (see Special Report, page 57).

Kuwait’s parliament is dominated by a variety of interest groups that revolve around the country’s powerful commercial families.

National Assembly delegates form loose-knit blocs, which at best lack a coherent agenda and are at worst self-serving.

“The quandary for people looking at Kuwait is that it is not a handful of royals driving development, it is a substantial number of leading families with competing interests and religious views,” says Pfeiffer.

“It is a small economy, so they are competing on almost every leading tender.”

The proposed legalisation of political parties, which are currently barred by Kuwaiti law, could help to alleviate the deadlock.

“Political parties should be a part of the government’s vision,” says Jasem al-Sadoun, managing director of the local Alshall Consulting. “You cannot rule a country without them.”

The fragmentation of Kuwaiti politics is exacerbated by the government’s own lack of authority.

“It is not that parliament is so strong, but that the government is so weak,” says Al-Sadoun.

“If you do not use your power, people will take it. Parliamentary groups are running for popularity and support by taking the country’s wealth and giving it to their supporters.

It is a disastrous situation. The government is not ruling the country.”

Some progress has been made on economic reform. Legislation was introduced in February to reduce the corporate tax rate to 15 per cent, from 55 per cent.

“Since the law was introduced, the number of foreign accounts opened by institutional investors has quadrupled,” says Salah al-Fulaij, chief executive officer of NBK Capital, the investment banking arm of National Bank of Kuwait.

Piecemeal reform

Progress on corporate tax reform offers hope that more can be achieved.

“The political stalemate will continue to represent a challenge for the reform process, though the government’s ability to push through certain measures over the past 12 months highlights the potential for further piecemeal reform,” says one senior banker based in Kuwait.

More change is on the horizon. A bill is being drawn up for the introduction of a capital markets authority to regulate the KSE, the GCC’s oldest stock market but the last to remain unregulated, and is expected to become law by the end of 2009.

“We have to lift ourselves out of the malaise of the past 20 years,” says Pfeiffer.

“If we do not get to it, we will be too far behind and Kuwaiti companies will not be in a competitive position if liberalisation occurs in the future.”