The Way Out of the Financial Crisis: Some Guidelines
In this section we propose a number of urgent actions that need to be undertaken immediately to deal with the severe economic phenomena that the economy is suffering from. These actions need to be implemented within the next twelve months and not to be delayed.
Injecting More Liquidity in the Economy
Even though the global financial crisis may be called a problem of shortage in liquidity in the banking system in most of the affected countries, in Kuwait it is not. The banking system in Kuwait has accumulated sufficient liquidity despite the crisis, thanks to the growth in private and public deposits. For example, between February of 2008 and February 2009, private deposits grew by 19%, while public deposits grew sharply by 71% due to instructions by the Central Bank.
This, however, does not mean that there is no liquidity problem in Kuwait. The nature of the liquidity crisis in Kuwait is somewhat different. Unfortunately, liquidity has stopped at the doors of banks and didn’t flow to the real and financial sectors of the economy. This is mainly due to the reluctance of the banks to extend credit in the midst of the crisis.
The Central Bank has to effectively use monetary policy through lowering interest rates in order to lower the cost of credit and stimulate private investment. Interest rates in Kuwait are still relatively high and have to go down, especially that the margin between interest on the KD and the US Dollar has reached a historical level of more than 3% in 2009.
Encouraging Financial Institutions to Expand Credit
Banks have been reluctant to lend due to, sometimes, unjustified risk averse behavior. This arises, in part, from two sources; the collapse in the market value of collaterals provided by borrowers, namely, stocks and real estate assets, and also due the absence of loan guarantees from the government. For example, the growth rate of new loans provided by banks to the private sector (excluding personal loans) has fallen from 89% between January 2007 to January 2008, to only 43% from February 2008 to February 2009.
To solve this problem, the government has to put in force proper mechanisms that give both incentives and guarantees to banks to perform their traditional role of providing credit to other sectors of the economy. A good starting point was the adoption of the Financial Stability Law (FSL) and its bylaws in early April of 2009. The FSL provides government guarantees up to 50% of new loans to productive sectors of the economy. However, this may not be enough to convince banks to speed up lending. Two other processes are needed, One to work on, at least, stabilizing the prices of financial and real estate assets used as collaterals in lending and another is to lower interest rates to reduce the cost of credit, both for new and outstanding loans.
Enhancing Confidence in the Stock Market
Many investors have lost confidence in the Kuwait Stock Exchange (KSE) due to its sharp decline since September 2008 and the large swings in stock prices for, sometimes, unjustified reasons. Many analysts have described the situation in the stock market as a “crisis of confidence”. This name was given because at that time all indicators were still positive, both at the micro and macro level. Everyone thought that the situation was under control, and that Kuwait was isolated from the global crisis. Unfortunately, the situation has severely deteriorated by the beginning of 2009 and everyone seemed to have underestimated the severity of the crisis.
In recent months, Kuwait Investment Authority (KIA) has entered the market as a buyer, to strengthen confidence and prevent more collapse in stock prices. However, even if the KIA was able to stabilize, or even raise stock prices in the short run, this would not be sustainable in the midst of the crisis.
What is needed is a number of steps including strengthening of laws and procedures and a stricter enforcement, including:
Stricter enforcement of information disclosure law
Stricter rules for listing of companies
Tougher actions against unlawful practices by listed companies, brokers and traders
The Arab Planning Institute (API) has recently issued a report on the international financial crisis and its impact on GCC countries. The API proposed framework to enhance market efficiency is based on improvement of the institutional and legal frameworks and rules of disclosure. In addition, it proposed the following actions:
Separation of supervision and administration of the stock market
Deepening the market through the establishment of new financial tools
Raising transparency standards through:
Reviewing stocks’ listing requirements, trading rules, and disclosure standards
Providing reasonable and quick rules for securities’ trading settlement
Setting professional standards for brokerage companies and their agents
Ensuring financial soundness of brokerage companies
Setting rules consistent with transparency requirements with regard to corporate governance for listed companies
Strengthening the electronic trading system to absorb more information and then make them available to market traders
Strengthening Supervision Of Financial Institutions
Another feature of the global financial crisis is the lack of sufficient supervision on financial institutions. Kuwait is not an exception in this phenomenon. The financial crisis in Kuwait has uncovered many shortcomings, mistakes and unlawful practices within many financial institutions. The Central Bank of Kuwait (CBK) is known for being tough in applying the rules of supervision on the banking sector. This may be supported by the fact that only one local bank was partially affected by the financial crisis. However, what surprised many observers was the loose supervision the CBK had over investment companies. Many investment companies have, systematically, used a number of unethical accounting practices to deceive shareholders, lenders and supervising authorities, namely the CBK. These companies have worked for a long time to make their financial statements look attractive through a number of practices such as inflating asset values and profits in order to be qualified to obtain more credit. In fact, many of them have excessively borrowed, using whatever available tools ranging from short-term to long-term, from local as well as foreign sources, from banks and from issuing debt instruments. They used a large portion of the obtained credit in buying very risky assets, namely stocks.
The current crisis has shown the need to strengthen supervision on financial institutions in general and investment companies in particular through both amending existing laws and tough enforcement.
In its last meeting in London in April 2009, the G20has set forward an action plan to strengthen guidelines and supervision to reform the regulation of the financial sector. Some of the elements that can be applied in Kuwait are as follows:
The G20 has agreed that all systemically important financial institutions, markets, and instruments should be subject to an appropriate degree of regulation and oversight. In particular:
Until recovery is assured, the international standard for the minimum level of capital should remain unchanged
Where appropriate, capital buffers above the required minimal should be allowed to decline to facilitate lending in deteriorating economic conditions
Once recovery is assured, prudential regulatory standards should be strengthened
Risk-based capital requirements should be supplemented with simple, transparent, non-risk based measures that are internationally comparable and properly take into account off-balance sheet exposures
The scope of Regulation
The G20 has agreed that all systemically important financial institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight. In particular:
Amend regulatory systems to ensure authorities are able to identify and take account of macro-prudential risks across the financial system; including the case of regulated banks, shadow banks, and private pools of capital to limit the buildup of systemic risk
given their systemic importance, large and complex financial institutions require particularly careful oversight
Ensure that national regulators possess power to gather relevant information on all financial institutions, markets, and instruments to assess the potential for their failure or severe stress which contribute to systemic risk
Review and adapt the boundaries of the regulatory framework regularly to keep pace with developments in the financial system and promote good practices and consistent approaches at the international level
The G20 has agreed that accounting standard setters should take action to:
Reduce the complexity of accounting standards for financial instruments
Strengthen accounting recognition of loan-loss provisions by incorporating a broader range of credit information
Improve accounting standards for provisioning, off-balance sheet exposures and valuation uncertainty
Boosting Public Expenditures
The role of fiscal policy in Kuwait contradicts the basic principles of modern macroeconomic theory. According to the theory, the fiscal policy should be countercyclical, while in Kuwait it is pro-cyclical. That is, theory requires boosting government spending (expansionary fiscal policy) during recessionary periods and tightening it (contractionary fiscal policy) during inflationary periods. In other words, fiscal policy is a stabilizing economic tool, rationally used by the government.
Unfortunately, in Kuwait the size of government spending is solely determined by the level of oil revenues. Therefore, during good times when oil prices are high and the private sector is booming, the government boosts spending, which certainly raises demand for goods and services and, thus, causes inflation. Meanwhile, during bad times, as it is now, where oil prices are low and the private sector is shrinking, the government has decided to cut-back expenses by about KD 7 billion (about 36%) in its 2009-2010 public budget. What is worse is the reduction in chapter four of the budget, which includes spending on construction projects, maintenance and land acquisition by 26.7% compared to 2008-2009, and by 40.7% compared to 2007-2008.
What is needed now is to reconsider the role of fiscal policy in the economy and use it as a stabilizing tool. The government should not set the level of expenditures solely on the basis of whether the public budget will incur a surplus or a deficit, but on requirements of economic stability.
Establish the Financial Market Authority
The establishment of the Financial Market Authority (FMA) has been an overwhelming issue in debates by government officials, members of the Parliament, Union of Investment Companies, the Chamber of Commerce and Industry, and academics as well. The need to create the FMA arises from the current situation in which the administration of the Kuwait Stock Exchange (KSE) plays two contradictory roles at the same time. On one hand, it plays an executive role in the market, while on the other hand it plays a legislative role, i.e. issuing rules and procedures.
The debate arises because every group in the economy is lobbying to tailor a law that maximizes its benefits or the benefits of the group it represents. In the last few years, a number of drafts were proposed from different groups. However, the Financial and Economic Committee of the previous Parliament did discuss one draft. Unfortunately, the Parliament was dissolved in March of 2009 before the committee issued its final draft. Therefore, we have to wait for another few months until the current Parliament re-discusses the draft again.
In this section we propose a number of actions that need to be taken to deal with the negative impact of the crisis on the economy. However, these actions are not urgent and may be implemented within one to two years as their implementation needs more complicated procedures, relative to the immediate actions. Such procedures include either creation or amending of laws and/or establishment of new public institutions.
Reviving the Real Estate Sector
In any economy, the real estate sector is a thermometer for the health of the economy, i.e. it signals whether the economy is growing or contracting. In addition, the real estate sector has very strong links with other sectors of the economy, namely, raw materials, processed and final products, and a number of durable goods.
The real estate sector in Kuwait has been witnessing continuous contractions and deterioration in its main indicators since the beginning of 2008 (i.e. volume of transactions and unit values). Most of the reasons behind this contraction have no direct relation with the financial crisis but have coincided with it. We will first discuss these reasons and then the reasons directly related to the crisis. The first factor is the amendment of law number 105/1980 related to the allocation of public land for private uses. In 2008, the Parliament passed two laws; number 8/2008 which prohibited companies from using public land as collateral to obtain credit to finance their Build Operate Transfer (BOT) projects, while law number 9/2009 prevented finance and constructions companies from the acquisition of private residential properties. Meanwhile, the second factor is the Central Bank’s instructions to tighten personal credit. And finally, the Central Bank’s decision to raise weights of collaterals against loans.
The direct reasons for the real estate’s problems are mainly two. First, commercial banks’ tightening of credit facilities provided to the real estate sector. Second, the increase in the supply of properties offered at the market by borrowers who were forced to do so as a result of facing difficulties in repaying their debts.
In order to revive the real estate sector, we propose a number of actions. First, the government should re-offer new BOT projects to the private sector after putting them on hold since the beginning of 2008. Second the government is required to promptly implement the Economic Stability Law, which provides government guarantees to 50% of banks’ credit, critical to the real estate sector. Finally, the government is urgently required to kick-off the long waited, and unjustifiably delayed, public mega projects.
In 2007, McKinsey Company, in its report “Developing Kuwait into a Financial and Trade Center”, has analyzed the land market in Kuwait and found that the private land market is extremely shallow and land prices are too high. Public industrial land is granted through a highly bureaucratic and lengthy process, leading to very high black-market prices. McKinsey has proposed four initiatives to make land a competitive advantage to Kuwait:
Implement the land master plan: The Government has taken the initiative to prepare a land master plan, but it hasn’t implemented it yet. The master plan has to be approved as a road map for future uses of land.
Auction government land and establish a secondary market for industrial land: The Government should consider auctioning land to increase the supply for both commercial and industrial uses. Establishing a secondary market for industrial land would be of additional benefit.
Leverage master and real estate developers: The involvement of master and real estate developers can be substantially expanded. The government will benefit from their professional expertise, additional capital and a sharing of risks
Establish a Central Land Authority and strengthen land regulation: A Central Land Authority should be established to take the lead in the implementation and monitoring of the zoning master plan. It will also be responsible to create transparency in the land market and monitor its health.
Expanding the Financial Instruments in the Financial Market
One of the shortcomings of Kuwait’s financial system is the narrow range of financial products available to investors. Investors usually have to make a hard choice between two extreme instruments that have different set of characteristics; i.e. liquidity, risk and return. Namely, we are talking about bank deposits and stocks.
Investors in general and individuals in particular need to have a more diversified menu of financial products that best fit their needs and their appetite towards risk. There need to be an active secondary market for debt instruments, both public and private. In addition, other instruments may be offered to investors, including convertible bonds and preferred stocks.
Improving Business Regulations to Enhance Transparency
A key source of Kuwait’s continuous Government-Parliament conflicts is the way the government allocates public tenders and projects to private companies. The Parliament criticizes this process as it sometimes lacks appropriate standards of transparency. For example, in some cases, projects and public land were allocated to private companies without going through the procedures of the Central Tender Committee and Public Land Law (105/1980).
In 2006, the Ministry of Finance, with the help of the World Bank, prepared a comprehensive law that specifies all sorts of collaboration between the public and private sector, known as Public-Private-Partnership (PPP). The main advantage of the law is the rule of transparency and competition in allocating public land and projects to private companies. However, the law’s draft is still waiting to be discussed in the Parliament. In addition, the Tender Law of 1964 needs major amendments to improve criteria of awarding tenders to private firms.
Upgrading the Infrastructure
Infrastructure plays an essential role in the overall competitiveness of business and economic activities by providing easy access to markets and sources of information. In general, Kuwait has a reasonably well-established infrastructure that has served the needs of the business community. However, there is a need to boost investment in infrastructure, both physical and human, for two reasons. On one hand, there is a need to upgrade infrastructure’s quality to improve Kuwait’s regional competitiveness, but on the other hand, investment in infrastructure could be utilized as a tool to speed up recovery after the financial crisis. In particular, the following actions should be taken. First, the port-airport operation should be streamlined and made efficient by inviting private companies with the necessary expertise in the operation and management of ports. Second, upgrade telecommunication network through expanding and upgrading the telecommunication network with the latest technology (i.e., fiber optic cables). Given the importance of communication and data transmission in a digitized global economy, it is essential that these plans are implemented on a priority basis. Finally, necessary investment in the electricity supply industry (generation capacity and transmission and distribution networks) should be undertaken. Furthermore, to improve the overall quality of supply, more efficient production and distribution is required. Private companies should also be encouraged to invest, operate, and manage the electricity and water supply industry.
To improve overall efficiency and competitiveness, it is important that private companies’ participation in economic activities is enhanced. This can be achieved by transferring state-owned entities to private companies, allowing private companies to establish new firms in activities where at present they do not have any role. In this context, it is important that the authorities rapidly and quickly prepare a list of activities that can be targeted for private sector participation. For instance, the government should open up the downstream oil industry to the private sector and encourage it to acquire the necessary know-how and technology through collaboration with multinational companies. It is vital that relevant laws that accelerate the privatization process and institutionalize the transformation are passed in cooperation with the parliament. However, these plans would not be practically implemented without a long-term government vision that clearly specifies the roles of government and the private sector in the economy.
Implementing Principles of Good Governance
The current financial crisis is best described as a crisis of ethics as it unveiled the considerable spread of unethical practices in financial sectors around the world. In the last two decades, the principles of corporate governance have received considerable acceptance around the world. O'Donovan (2003) defines corporate governance as “an internal system encompassing policies, processes and people, which serve the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity, accountability and integrity”. In 2006, the UNCTAD issued a report on principles of corporate governance disclosure. Below is a summary of the major principles.
Enterprises should disclose their financial and operating results: The board of directors is responsible for providing shareholders and other stakeholders with high-quality disclosures on the financial and operating results of the company.
The board’s responsibilities regarding financial communications should be disclosed: A description of the board’s duties in overseeing the process of producing the financial statements should be provided to support the notion that the board is responsible for creating an overall context of transparency.
Enterprises should fully disclose significant transactions with related parties: Many shareholders and stakeholders would be interested in information that would help them determine that management is running the enterprise with the best interest of all shareholders and stakeholders in mind and not to unduly benefit any related parties.
First: Governance Structures and Policies
The composition of the board should be disclosed: The balance of executives and non-executive directors, and whether any of the non-executives have any affiliations with the company. Where there might be issues that stakeholders might perceive as challenging the independence of non-executive directors, companies should disclose why those issues do not impinge on the governance role of the non-executive directors as a group.
The board’s role and functions must be fully disclosed: Most guidelines and codes of best practice emphasize the stewardship and supervision functions of the board and distinguish its responsibilities from those of management. It is important that directors disclose what their functions and retained powers are; otherwise, they may be held accountable for all matters connected with the enterprise.
Second: Board Committees
Governance structures should be disclosed: The board should disclose structures put in place to prevent conflicts between the interests of the directors and management on the one side, and those of shareholders and other stakeholders on the other. These structures may include committees or groups to which the board has assigned duties regarding the oversight of executive remuneration, audit matters, appointments to the board, and the evaluation of management performance.
The composition and functions of any such groups or committees should be fully disclosed: Committee charters, terms of reference and other company documents outlining the duties and powers of the committee or its members should also be disclosed, including whether or not the committee is empowered to make decisions that binds the board, or if the committee can only make recommendations to the board. Another thing to be disclosed is whether any director has taken on a specific role for the board or within one of these structures.
Third: Ethics Policy And Support Structure
The existence of an enterprise code of ethics and any governance structure put in place to support that code of ethics should be disclosed: Ethics management is important for the promotion of good business practices, transparency and risk reduction. As ethics management becomes more common in enterprises, the existence of its key structural features is an important area of disclosure.
Some possible features subject to disclosure might include: the existence of a senior ethics officer and that person’s responsibilities; the existence of an ethics committee and its relationship to the board; policies for breaches of the ethics code, including reporting mechanisms and "whistleblower" protection mechanisms; and policies on the dissemination and promotion of the ethics code.