NEW YORK: Moody’s Investors Service, (“Moody’s”) has downgraded Kuwait’s long-term foreign and local currency issuer rating to A1 from Aa2, and changed the outlook to stable, concluding the review for downgrade initiated on 30 March 2020. The decision to downgrade the ratings reflects both the increase in government’s liquidity risks and a weaker assessment of Kuwait’s institutions and governance strength. In the continued absence of legal authorization to issue debt or draw on the sovereign wealth fund assets held in the Future Generations Fund (FGF), available liquid resources are nearing depletion, introducing liquidity risk despite Kuwait’s extraordinary fiscal strength.
While the fractious relationship between parliament and the executive is a long-standing constraint on Moody’s assessment of institutional strength, the deadlock over the government’s medium-term funding strategy and the absence of any meaningful fiscal consolidation measures point to more significant deficiencies in Kuwait’s legislative and executive institutions and policy effectiveness than previously assessed.
While liquidity risks are particularly relevant in the next few months, over the medium term next one or two years, upside and downside risks are broadly balanced reflected in the stable outlook. Kuwait has a vast stock of sovereign financial assets currently ring-fenced from the general budget by law, securing predictable access to which would eliminate government liquidity risk.
Conversely, Moody’s sees a continued risk that the executive and legislature perpetuate stop-gap measures in response to the funding impasse, without providing lasting visibility on the funding of Kuwait’s budget. While not Moody’s expectation, government liquidity risks would manifest if continuing gridlock over funding led to the exhaustion of available liquid resources ahead on the maturity dates of Kuwait’s international bonds, including the $3.5 billion tranche maturing in March 2022.
Kuwait’s foreign currency bond ceiling has been lowered to Aa3, from Aa2 and the foreign currency deposit ceiling has been lowered to A1 from Aa2, whereas the short-term ceilings remain at Prime-1 (P-1). The local currency bond and deposit ceilings have been lowered to Aa3 from Aa2U.
Rationale for downgrade
Government liquidity risk has risen in the absence of legal authorization to issue debt or access the future generation fund. With a government debt law yet to be passed and General Reserve Fund (GRF) assets likely to be deplete before the end of the current fiscal year (ending in March 2021), government liquidity risks have increased. Legislation passed by parliament so far, including the removal of the mandatory transfer of 10 percent of government revenues to the FGF and the reversal of last year’s FGF transfer have only extended the point of depletion to December 2020.
Even if the debt law is passed-whether by parliament or by decree from HH the Amir while parliament is in recess-it will likely not provide a credible medium-term funding strategy, which was a key driver behind Moody’s initiating the review for downgrade in March. The draft debt law, which has already been rejected once by the parliamentary financial and economic committee, contains a KD 20 billion debt ceiling which would be reached in less than two years under Moody’s baseline scenario.
A lower ceiling possibly to wield parliamentary approval would be exhausted even earlier given the large size of the government’s immediate and medium-term funding requirements. Even if the government received legal authorization to issue debt without the constraint of a ceiling, Moody’s projects net sovereign issuance of up to KD 27.6 billion ($90 billion would be required to meet the government’s funding requirements between the current fiscal year and the fiscal year ending March 2024, testing the capacity of the government to access such large financing.
Kuwait has one of the largest stocks of sovereign financial assets in the world, both in absolute terms and relative to the size of the economy and government debt burden. Securing predictable access to these funds would eliminate government liquidity risk. However, these funds are explicitly ring-fenced from the general budget by law. While the mandatory budget transfer to the FGF has been suspended, the government has not given any indication nor made any formal request to parliament to access FGF assets or income. Should the request come through, it would be politically contentious and likely take a long time and multiple versions to secure legislative passage. In the meantime, government liquidity risks will remain elevated
Medium-term funding situation
The fractious relationship between parliament and the government is a long-standing and well-known feature of Kuwait’s credit profile. While active debates in parliament contribute to checks and balances, when the process is not conducive to agreement-seeking, it hampers policymaking. Historically, the impact of government inertia on the sovereign credit profile has not been so significant since Kuwait long ran large fiscal and current account surpluses.
However, in an environment of structurally lower oil prices and growing government expenditure, the ongoing delay in finding a durable solution for Kuwait’s medium-term funding presents a more acute risk to the sovereign credit profile. The persisting deadlock addressing the funding situation now directly threatens the ability of the government to function, representing a significant escalation in the brinksmanship between the two branches of government.
Capacity of fiscal policy to respond to shocks
Moreover, the government’s continued inability to respond to severe revenue shocks from oil prices points to even weaker fiscal policy effectiveness than previously assumed. In contrast to earlier statements from the government that it would seek to reduce its expenditure in year-on-year terms, the passing of the budget for fiscal year 2020/21 incorporates a 1.6 percent increase in expenditure, despite a budgeted 56 percent decline in revenues.
Kuwait has also made limited progress in reforming subsidies, which account for 22 percent of government spending. In particular, non-energy subsidies, which includes a broad range of subsidies covering services like healthcare and education abroad, have also remained largely untouched due to parliamentary opposition. Kuwait’s revenues remain highly dependent on hydrocarbon receipts, which averaged 89 percent of government revenues between 2017 and 2019. Progress in diversifying the non-oil revenue base has been very slow, in part due to parliament’s resistance to any measures that would reduce the living standards of their constituents.
The implementation of a 5 percent VAT, as part of the Gulf Cooperation Council (GCC) -wide post-2014 oil price shock initiative is the single largest revenue measure that the government has explored. However, Kuwait’s parliament has still yet to ratify the VAT treaty which would precede any VAT legislation, and Moody’s now expect the implementation of VAT to be between 2022 and 2023 at the earliest, contrary to earlier indications from the government that it would be in place by 2021. An excise tax on sugary drinks and tobacco which was planned to be implemented this year has also been delayed.
Given the absence of any meaningful adjustment following the 2014-16 and the more recent oil price drops, Moody’s expects the government budget deficit will reach KD 13.7 billion (38 percent of GDP) this year. While, Moody’s expects a reduction in the fiscal deficit in the fiscal year 2021/22 to KD10.6 billion (25.7 percent of GDP), this is underpinned entirely by a higher oil price assumption and increased hydrocarbon production volumes as the OPEC+ production caps taper.
Furthermore, Moody’s expects that fiscal consolidation will prove challenging due to the government’s inflexible spending structure. Current expenditure has increased cumulatively by over 20 percent since the end of the fiscal year ending in March 2016, which has been driven predominantly by increased spending on government salaries and compensation. Projected growth in the Kuwaiti labor force due to the country’s young demographics, the government’s status as employer of first resort, and limited tolerance among the leadership for higher unemployment are likely to continue to drive growth in government payroll expenditure unless employment opportunities in the private sector increases significantly or the government is prepared to tolerate higher unemployment, neither of which represents Moody’s baseline expectations.
Rationale for stable outlook
While liquidity risks are particularly relevant in the near term, over the medium term upside and downside risks are broadly balanced reflected in the stable outlook. On the downside, the likelihood that the executive and legislature continue to deliver only piece-meal, make shift measures means that uncertainty over the funding situation will persist. The liquidity risk generated by the persisting legislative impasse represents a low probability but high severity tail-risk event.
While not Moody’s expectation, government liquidity risks would manifest if continuing gridlock over funding led to the exhaustion of available liquid resources ahead of the maturity dates of Kuwait’s bonds, such as the $3.5 billion Eurobond tranche maturing in March 2022.