Majdi Gharzeddeene, Head of Investment Research, Kamco Image Credit: Supplied

Please describe the essential characteristics of the Kuwaiti financial sector, by comparison with the other Gulf states, in terms of proportional presence of the variety of institutions. Has the structural balance of the system of entities itself created strengths or weaknesses, or has the main issue been instead how institutions have behaved within the environment in which they operate?

The Kuwaiti financial sector is divided into four categories — commercial and Sharia-compliant banks, conventional and Sharia-compliant investment companies (ICs), consumer financing, brokerage and exchange companies. Financing activities are dominated by banks, with a small contribution from consumer financing facilities companies, while ICs are involved in providing asset management and financial services.

In addition to local banks, ICs are considered as a major player in the asset management segment and compete with local banks in terms of assets under management (AUM). However, the number of ICs is large when compared to the GCC states (102 companies compared to 104 for the other five GCC states).

The IC sector is highly fragmented with 80 per cent of AUM ($46 billion, Dh168.9 billion) held by a few leading firms. The increase in the number of ICs in Kuwait was driven by the increasingly attractive investment returns during the past years prior to 2008, rather than the ability of those companies to form a large client base and generate fee-based income.

The way ICs were structured created inherent risk, as they relied on markets performance to generate the bulk of their revenues. The issue was also magnified with the way ICs behaved within the environment in which they operated as their risk appetite increased with time, and in an effort to meet their targets of higher profits they added further systematic risk and return by increasing the use of financial leverage.

The results were ultimately catastrophic for the sector once it was hit by the financial downturn, as many ICs witnessed a large part of their shareholders' equity base erode and many faced severe solvency problems.

Turning to performance per se, we have heard of the difficulties associated with the credit crisis, for instance regarding investment companies and money market funds. What too is the standing of the banks now? How do the problems interact with each other, and what does it mean for working out a solution?

Despite modest improvement in the availability and terms of credit for corporate borrowers, credit for ICs is still strained owing to worries by banks about the quality and the fair value of ICs' investments and their vulnerability to the fluctuations in the equity markets which are facing tight liquidity and lack of investors' confidence.

The result is likely to be a weak pace for the investment sector's recovery and a long period of weak profitability that might extend for the next two years. Highly leveraged ICs (with total outstanding debt of $27 billion) may face additional problems during this year, and could possibly not be able to return back to profitability; that's triggered by the lack of investor confidence and the depreciation in asset prices, which was revealed in the enormous losses reported in 2008 and 2009, together amounting to $5.2 billion.

Regarding money market (MM) funds, which are seen as a safe and liquid investment for both institutions and individuals, there are relatively few MM funds in the Gulf, but Kuwaiti ICs and banks manage dozens, and we estimate that assets of MM funds reached a peak in 2008 of $3.45 billion.

Triggered by the credit turmoil, aggregate losses in the net asset value (NAV) of MM funds we estimate at 30 per cent, which when combined with redemptions have reduced AUM to about $2.25 billion. Losses could mount further because some funds have yet to book full provisions against their credit losses as most of the MM funds are now in trouble, and the net asset values have significantly slumped.

Financial-year 2009 results of the Kuwaiti banks, which came in at $1.2 billion, were in line with the regional and global economic slowdown. Hence, our view of the banking sector's foreseeable outlook is to maintain its concrete economic position in the market as one of the major sectors.

Despite the economic slowdown and suspicions shadowing the equity markets, tumbling property prices and tight credit conditions, Kuwaiti banks are gradually expected to recover from the impact of the crisis on the back of the fiscal stimulus plan initiated by the government along with the continuous support of the Central Bank of Kuwait, while posting lower profitability levels compared to the period preceding the crisis.

Although Kuwaiti banks have maintained sound asset quality during the historical periods, we believe that the situation changed during 2008 and 2009 and may deteriorate further in 2010 and 2011.

The asset quality of the banking sector becomes paramount as the non-performing loans (NPL) to gross loans ratio rose to 9.7 per cent as of December 2009, up from 5.7 per cent and 2.9 per cent as of 2008 and 2007 respectively.

Loan loss provisions (LLP) booked during last year amounted to $2.6 billion, which weighed down on the sector's profitability; LLP charged during 2008 hiked to $3 billion on the back of defaults by local ICs, which weighed down on the quality of banks' loan portfolio represented by the rise in NPL to $10.4 billion as of December 2009 compared to $5.9 billion and $2.4 billion at the end of 2008 and 2007 respectively.

Hence, we believe that LLP will continue to put further pressure on banks' profitability over the foreseeable future due to the possible defaults by some ICs, which are currently facing solvency problems.

As for the solutions to the current liquidity squeeze and lack of confidence, we believe that ICs' balance sheets should be strengthened initially through a combination of equity financing and long-term funding instead of short-term, along with restructuring the outstanding debt and operations through focusing on core business activities. We believe that sustainable expansion and profitability could be achieved through this process, which would contribute to a sustainable recovery of the asset management and investment banking business and the local bourse in the coming two years.

Moreover, ICs in Kuwait are still facing insolvency problems, and a significant number of Sharia-compliant and conventional ICs are insolvent, owing to the high exposure to short-term financing and the devaluation of financial asset prices. To save their assets from further devaluation, we recommend that ICs attempt mergers and acquisitions as a means of capturing a continuous influx of cash and reducing operating expenses in order to restore profitability and avoid further losses.

Taking the financial sector as a whole, including the stock market, how would you then describe the connections with the performance of Kuwait's economy, considering that the country is so oil-rich and pursues a conservative strategy in its budgetary assumptions?

The Kuwait economy is oil-dominated, with the oil sector accounting for around 60 per cent of the aggregate. The performance of the financial sector in Kuwait is highly correlated to the real estate and stock market, as local ICs are highly exposed to the local bourse while local banks have high exposure to the real estate and investment sector.

I believe that the future performance of the banking sector is conditional to other sectors' performances, mainly the investment and real estate sectors and stock market, which together account for 49 per cent ($42 billion) of local banks' credit portfolios, which, in turn, places pressure on the banks' asset quality specifically in case of a further default by the highly leveraged real estate firms and ICs. Moreover, banks would benefit from the new economic development plan, given that it is on the right track.

What comments would you have about the regulatory mechanisms or legislative frameworks or interventions which may either hinder or enhance financial development, and what are the prospects?

The approval of the Capital Market Authority (CMA) law by the Parliament to regulate and overlook the activities of the KSE will play a vital role in attracting additional investors — local and regional — in the future to invest excess funds in the local bourse. Enhanced levels of transparency will lure foreign investments to be directed towards the exchange, which has been plagued by irregularities in trading, prices and disclosures.

The crisis also shows that financial development in Kuwait needs to go hand in hand with: better and broader financial regulation and supervision by the regulatory authorities, enforcement of the new CMA law, and implementation of regulatory reforms to monitor the activities of listed companies and ensure that such crises may be avoided in future.

I believe that the major challenges that policymakers in Kuwait currently face are: (i) to ensure that local banks can support economic recovery by encouraging lending to productive economic sectors; (ii) to put in place financial reforms that may prevent a similar crisis in the future; effective market discipline needs to be encouraged through greater transparency and corporate governance in Kuwaiti firms.

Can you tell us about latest developments in Kuwait's frequently-stalled project investment programme, which has generally been blamed for the slower development of a diversified economy? What does it mean particularly for financial development?

The new $104 billion plan was approved on February 2 in the Kuwaiti Parliament. In our opinion, since this is the first development plan for the State of Kuwait since 1986, the government will be putting further pressure on implementing these measures as the adverse effects for not doing so are immense, especially with the lagging recovery of the private sector.

The new plan has allocated spending on development projects through five shareholding companies. The aim of the new plan is to turn Kuwait into a regional trade and financial centre by using oil revenues in boosting non-oil sectors and thereby gradually decreasing the country's dependence on oil.

Initial figures provided estimated spending from the development plan during the next fiscal year starting April 1 this year to be approximately $16.5 billion, with $7.7 billion to be allocated for oil projects and $8.8 billion for non-oil projects.

Spending on non-oil sectors includes health, education, power, transportation and infrastructure projects.

Given the estimated $230 billion in government reserves along with the continued recovery in oil revenues for the near future, the government should face no challenges in providing the money for the plans.

However, spending the $16.5 billion is not an easy task, and we expect that there will be some setbacks because of the limited capability of local contractors, keeping in mind that capital expenditures by the government averaged around $3.9 billion per annum over the pastfive years.

Is there any particular relevance in any of these contexts to the role of the exchange rate, and the outlook for potential monetary union, noting that Kuwait has been following a slightly different path in currency management from its GCC counterparts?

Any development in the GCC monetary union would be affected by the monetary and fiscal policy of each country. However, Kuwait is an exception in the Gulf as it pegs its local currency to a basket of major international currencies while other GCC states' currency is pegged exclusively to the US dollar.