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ByAyah El SaidandRachel Ziemba

This could be the latest new tool in Kuwait’s tool box, and such plans come less than a week after the central bank proposed a third round of stress tests. While details have yet to be released – and there is still reportedly some concern about who and how it might be administered, this could  be a step in the process of rescuing Kuwait’s financial sector, though only if it is done transparently.

Following the rescue of Gulf Bank and the default of Global Investment House of one of its bonds last fall, the government has been rolling out new measures in the face of weaker risk appetite in the GCC and globally. On the financial side, it has provided capital to banks, guaranteed deposits etc. It has continued monetary easing and plans to maintain spending though the details of allocation are uncertain. The political stalemate in the Kuwait has not helped these responses and uncertainty about the exposure of corporations and investment companies, as well as the fear of asset ,market losses have kept banks unwilling to lend.  The default shed light on the vulnerabilities in other Kuwaiti institutions, underscored by a wave of banking downgrades in the GCC and in Kuwait’s overall banking system, towards the end of 2008 and start of 2009. Moreover, delays in reporting financial results led to trade of many financial and non-financial corporations in spring 2009. Although trading in most resumed after Q4 results were released, reports suggest that the same thing led authorities to stop trading today in 26 companies.

With Kuwait’s financial system was hard hit by the crisis, increasing the calls for the involvement of the KIA and political pressure for more intervention. However, despite the pressure on its financial institutions, Kuwait’s current NPL rate is relatively low (1.7%), lower than many of its neighbors and has been declining. Defaults rose briefly in mid 2008 after many individuals hoped that the government would pay off their debts but are still relatively low. But as noted below investment companies are vulnerable both to investment losses and to difficulty in attracting new funds as some local investors become more risk averse – the stock of GCC investment fund assets under management fell sharply since mid 2008 on investment losses and withdrawals.

However, there is also political pressure to provide transfers to individuals who may have suffered losses, a divide which may push such a response into the future. Despite some political paralysis, Kuwait’s government is now crafting responses in the hopes of improving the economic outlook, which include planned spending hikes, monetary policy easing both through issuance of t-bills and rate cuts. But the implementation of these policies is less than certain and a real GDP growth contraction should not be ruled out as the hydrocarbon sector contracts and government spending may have limited boost to other sectors.

What precedents for such an entity? Government mopping up of non-performing loans is not unprecedented. The government stepped in and bought up all of the non-performing loans (50% of outstanding pre-invasion loans) after the Iraqi invasion in the early nineties in exchange for government bonds. While the shock to the economy is much less now than in 1990-91 (when oil output was completely halted for months), this is a possible precedent for government intervention.

In the planned US PPIP, the government and private actors would jointly provide capital for purchasing the so-called legacy assets from the banks along with government loans. In Europe, German banks will be able to transfer their illiquid assets to a special purpose vehicle which could then issue government backed bonds. Other models might include the Asian asset management companies (themselves modeled on entities to recapitalize the US thrifts in the 1980s). In most cases, the non-performing loans were split off and sold to asset management companies in exchange for equity stakes in the AMC and capital injections. While several of these were successful, leading to stronger banks they were costly and relatively lengthy processes. Unlike the US and EU the fact that there is limited securitization might make the process for any so-called bad bank easier as it might be able to buy up the underlying assets.

Who Might Administer The Fund? There are reports that the Kuwait Investment Authority, the country’s sovereign wealth fund,  may be reluctant to administer such a fund and its potential role in addition to that of the private companies are unclear.

Kuwait’s sovereign wealth fund, has- like some of its neighbors -already been used to support its domestic markets. The KIA withdrew about $4 billion from international capital markets and created a domestic equity stabilization fund, extending its investments in domestic markets. It also provided capital to Gulf bank, the first regional bank to face financing issues, though capital injection and backstopping its capital raising. As such its domestic role has already become more pronounced and some of its savings, especially from the reserve fund, may well be used to meet budget shortfalls. Unlike its neighbors, Kuwait has been slower to start spending in the mid-2000s boom (in particular being delayed at boosting investment), but it is still at risk of a budget deficit in 2009 unless oil prices stay at their current levels given the anti-crisis measures.

The KIA has a large pool of assets, over $200 billion at the end of Q1 2009, by our calculations and a significant reserve of more liquid assets but there could be increasing call on these assets. Moreover, having moved more towards a university endowment style asset allocation, it also has significant equity and alternative assets which may be relatively illiquid. Moreover, despite the fact that it has increased its domestic holdings – in part to try to support domestic asset management –  it is primarily a fund that invests abroad, meaning that taking on management of such an entity might imply a significant change of focus. Doing so might actually mean more coordination with the central bank. However, either way, if private companies are involved, presumably it would be structured so that they could achieve some profit from the deal.

One of Kuwait’s neighbors- Qatar- announced in March 2009 its intentions to purchase listed shares in the investment portfolios of local banks to prop up the country’s financial sector. Qatar’s sovereign wealth fund, the Qatar Investment Authority (QIA), had already purchased 5% shares in the country’s domestic banks towards the end of 2008, and should acquire an additional 5% in 2009. Doing so was hoped to shelter financial institutions and allow them to begin lending and may influence Kuwait’s plans.  However most GCC countries are now having to respond to lower levels of credit growth than in 2007 and 2008 when inflows and easy money along with negative real interest rates fuelled bubbles.

Vulnerabilities/scope of relevant assets With the worsening economic outlook, faltering consumption and pressure on property markets from still-tight liquidity, it seems all but certain that NPLs will rise in Kuwait, though the question is by how much. The losses on local and global investments
may reduce cash flow and contribute to further defaults or non-payments from investment companies.  Some of the country’s long awaited investment plans may also be on hold as the government focuses on current not investment spending. Furthermore lack of transparency about corporate financials and the health of the banks exacerbate a reluctance to lend.  Generally, sluggish deposit mobilization, an unwillingness to extend loans, and fears over asset and loan quality, increase the pressure on the Kuwaiti banking system.

Kuwaiti banks also have indirect exposure to the country’s stock market, in the form of loans extended to distressed investment companies. Kuwait’s investment companies are the key vulnerability, as they have faced losses on property and especially the equity market. The Kuwait News Agency (KUNA) reported that Kuwait’s 99 investment companies lost 9.2 billion Kuwaiti dinars ($31.7 billion), or 30.6% of their assets value in the six months from August to January, as their investment portfolios fell sharply – especially their investments in local companies. While their portfolios may have regained some of those losses in the recent rally, they continue to be hard hit.

An Investment company, Dar, defaulted on its sukuk last week, the first Islamic bond default in this cycle, and more may well be coming. While investment companies may be the most vulnerable, other banks are exposed to the stresses of non-financial institutions. Corporations may also reduce payments. However the pace of defaults has slowed since last fall when expectations of government bailouts led to a deterioration of payments. Once it became clear that bankruptcy processes would be followed, some companies settled their debts rather than face the prospect of the lack of access to the banking system.

In December 2008, NBK conducted an exercise to measure the degree of exposure that non-financial services companies have to investments. The results of this exercise showed that companies borrow to invest in securities instead of investing in their core business. This implies that with their investment portfolios were battered, a considerable fraction of their equity base may be eradicated, creating further problems especially in terms of repaying their debts, let alone creating insolvency risks. Hence the importance of new measures to buttress the country’s financial and banking sector. The government’s monetary easing (it added another 50bps cut in early May) is part of the same policy agenda.

Despite  policy measures, and a planned third round of stress tests, Kuwaiti banks remain wary of resuming their lending after several companies announced debt defaults and foreign borrowing is harder to come by. Setting up such a ‘bad bank’, in addition to continued monetary easing, could be one step to credit flowing again and speed up the process of bank recovery. However this process may take time and is reliant on more transparency about the banks current capital base and possible liabilities. Such processes have been relatively slow to get off the ground in other countries and in Kuwait, there is a risk that any such program may be rather opaque, which would add to uncertainties. Yet it could be part of a more consolidated approach to the economic and financial sector.

And finally, might any other GCC countries follow? As mentioned, Qatar’s move to buy up the portfolios of investment companies and hold them until prices appreciate seems to be one form of isolating the under water assets, freeing up the institutions. Qatar’s government, through the Qatar investment Authority has simultaneously increased its stakes in local banks taking up to 20% stakes and boosting capital ratios. While their asset base may come under pressure, a more developed bad bank seems unlikely. The UAE is perhaps a more likely candidate though the institutional bases might differ. In practice the restructuring the UAE government is trying to orchestrate between Amlak and Tamweel, the mortgage issuers, might well be such a step to consolidate and sell off any bad debts. However, they will exist in a very different form, likely as a bank rather than as a stand-alone mortgage offerer. Similarly, one part of the wave of consolidation that we expect in the region may concern investment companies. These companies like the larger investment banks in the U.S. may well evolve into banks, adding retail and commercial deposit arms as they seek more sustainable and domestic capital sources.

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