The recent report published report by Kuwait Financial Centre (Markaz) analyses monetary policy options for Kuwait given the challenges it faces in the form of growing liquidity, inflation and challenges in using tools like interest rates and currency to contain inflation. M.R. Raghu, Head of Research states that “The monetary policy is surrounded by various factors, what we call as the vicious square, all exerting diverse influence”
The recent report published report by Kuwait Financial Centre (Markaz) analyses monetary policy options for Kuwait given the challenges it faces in the form of growing liquidity, inflation and challenges in using tools like interest rates and currency to contain inflation. M.R. Raghu, Head of Research states that “The monetary policy is surrounded by various factors, what we call as the vicious square, all exerting diverse influence”. Liquidity: Liquidity has experienced very sharp growth during the last few years, thanks to high oil prices. The challenge is to control its impact on inflation. Liquidity in Kuwait is primarily driven by oil price. While broad money would be a good benchmark to measure liquidity, bulk of the money supply comes from deposit growth. Banks that take these deposits lend it in the form of credit, which then forms the other side of the coin. Monetary policy makers are confronted with a heated up economy (thanks to oil price) that is driving the credit growth. While deposits grew at a compounded growth rate of 17% during the last six years, credit grew at 21%. It must be noted that there has been a significant pick up in the credit growth during the last three years relative to the earlier period. Credit growth would have been even higher but for the monetary tool in the form of Loan to deposit ratio that is currently pegged at 80%. Commercial banks are the direct beneficiary of this stupendous credit growth given the high margin (spread) between lending and deposit rates. Average spreads since 2001 is 337 basis points. For a long time (May 02-Jan 06), these spreads used to be more than the deposit rates! Inflation:. A direct fall out of following the US monetary policy is the spiraling inflation, the effect of which is quite well discussed and debated in public and professional forums. It is very clear that inflation is now a product of both domestic and foreign factors. Abundant liquidity leads to high credit growth (as exhibited in the earlier section) as well as increase in government spending which induces inflation. The imported inflation problem arises basically out of currency peg due to which non-USD imports are becoming expensive as the US dollar depreciates. This is particularly true for food items whose prices have been sharply escalating. A scenario where interest rates are decreasing (due to US monetary policy) while inflation is accelerating leads to negative real rate of interest. Some view inflation as a temporary problem and hope that it will subside as soon as global food prices moderate and US dollar starts strengthening. However, this may not necessarily be the case. It is interesting to note the measures Saudi Arabia has recently undertaken to tackle the inflation problem. Measures include increase in government salaries (though inflationary in nature, is aimed to empower people to tackle inflation) and decrease in costs of certain services. Kuwait has also recently announced increments in government salaries to the extent of KD 120 for nationals and KD 30 for expatriates. Currency: Currency has been at the heart of the debate. GCC countries provided exchange rate stability by pegging its currency to the US dollar. This served well when US dollar used to be a strong, stable and preferred currency all over the world. However, things have changed dramatically during the last few years when US dollar turned to be a weak, unstable and not-so-preferred currency on the back of high US deficits. However, GCC countries continued with their peg more for political reason than economic reason. US Dollar has depreciated nearly 40% against Euro and 30% against British Pound. Compared to this, the US dollar has depreciated only 11% against Kuwaiti dinar leaving a significant gap (Table-1). Kuwaiti dinar was pegged to a basket of currencies for a period of 25 years till 2002, when it was directly pegged to US dollar like other GCC countries. However, in 2007 Kuwait broke ranks with other GCC countries and again shifted the peg back to a basket of currencies primarily to contain inflation. The basket is estimated to be about 80% dollars, 15% euros and the remaining shared by British Pound and Japanese Yen though no official announcement to this effect has been done. Table 1: Currency Movement $1 fetched Pound Sterling Swiss Francs Japanese Yen Euro Kuwaiti Dinars 2001 0.696 1.668 132.690 1.131 307.483 2007 0.493 1.137 112.020 0.685 274.215 Change -29% -32% -16% -39% -11% Source: Central Bank of Kuwait and Markaz Analysis Interest Rates: The discount rate can be used as a benchmark rate for lending while the repo rate closely aligns with the Fed rate. Till Dec-04, the spread between discount rate and repo rate used to be – 50 basis points (negative). However, this turned into positive since then and the spread has been climbing higher and hovered around 75 basis points (positive). Since recessionary fears gripped US and the Federal Reserve started cutting rates aggressively, the spread has been widening and has reached a historic high of 225 basis points. This can be attributed to CBK’s need to follow the Fed rate. However, the central bank is reluctant to reduce the discount rate in tandem with a reduction in repo rate, for the fear of stoking inflation as reduction in discount rate would increase the credit growth. If the CBK breaks away from Fed and increases the repo rate (thereby bringing back the spread to its long-term average) then it will risk “carry trade” (borrow in US dollars and invest in KD) and bring un wanted pressure on currency. Hence, on the one hand the CBK wants to control speculators through lower deposit rates (thus making KD unattractive for carry trade options). On the other hand, CBK does not want to reduce the discount rate for the fear of stoking inflation through higher credit growth. A true dilemma indeed! The spread between KD deposit rate and US deposit rate has been narrowing, especially on the shorter maturities (3-months and lower) . For e.g., the current spread for a 3-month deposit is 14 basis points as against the historical average spread of 486 bps. However, for longer maturities (6-months and 1-year), the current spread is in alignment with historical average. Raghu expects the spread to continue to be narrow at the short end of the maturity spectrum. The report also expects the discount rate to narrow by 75 bps to 5% by the year end and the repo rate to contract by 100 bps . This is based on the expected evolution of Fed Fund rate and the likely response of CBK to the same. The consequence of these actions will be a likely expansion of spread (Discount-Repo) to 250 basis points from the current 225 bps. As per the report, the following could be the likely outcome of Kuwait monetary policy: 1. Banks may face pressure to contain credit growth through an increase in reserve requirement and reduction in discount rate. This will impact their profitability though they will be helped by a reduction in deposit rates. 2. Kuwait dinar will certainly appreciate in order to contain inflation, though the jury is still not out on the impact of appreciation achieved so far on inflation. Revaluation may not happen. Stock Market Implication: The implication of this for stock market may be muted, given the fact that lending rates do not move in tandem with discount rate. In other words, average lending rate will continue to be high or may moderate slightly. Hence, leverage trading (borrowing from banks and investing in stock market) may not be very profitable. Currency appreciation would certainly be a positive for foreign investors who have been immensely helped by the clarity on the taxation law, which now stipulates 0% tax on capital gains for trades done in Kuwait stock exchange. ### About Markaz Kuwait Financial Centre S.A.K. 'Markaz', with total assets under management of over KD1.3 billion as of December 31, 2007, was established in 1974 has become one of the leading asset management and investment banking institutions in the Arabian Gulf Region. Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997; and was awarded a BBB+ corporate rating by Capital Intelligence Ltd.