Sunday, December 6, 2009

Kuwait's Financial Crisis - Past and Present

Souk Al Manakh: How to resolve past mistakes

Souk Al Manakh has the honor of being the worst bubble in the history of the world. The bubble was so severe, that when the market crashed in 1982 it left the economy of Kuwait devastated and crippled for 9 years to come. The lingering effect was partly due to the government’s ineffective remedy. Today, there is a real risk of the same economic paralysis taking place again unless there is a serious joint effort taken by both the private and public sector to tackle the issue.

Souk Al Manakh

The large oil revenues that flooded the Middle East during the 1970’s left a huge cash surplus in the pockets of Kuwaitis. They sought an outlet to invest their wealth and finding a bear market in the US they turned to local investing. At the time, the official stock market only had a handful of listed companies which were seemingly uninteresting. This gave birth to an unofficial market dubbed Souk Al Manakh in 1981. The market was an over-the-counter market which specialized in unregulated non-Kuwaiti companies like those incorporated in Bahrain and UAE. The market quickly became a hotbed for speculators, reaching a market cap of USD 100 billion, becoming the 3rd largest stock market in the World after only the US and Japan, and ahead of France and the UK.

In Kuwait it was customary at the time for investors to use post-dated checks. A bank balance was not necessarily required to issue the checks, but the hope was that a balance would be available when the check was due. Families’ honor was the key driver of trust, making it almost unthinkable that these checks would bounce or default. However, human nature prevailed and eventually people became greedy and began to purchase stock with checks that couldn’t be paid. Billions of dollars worth of stock had been purchased using these checks causing the prices of stock at Souk Al Manakh to skyrocket increasing 61% in 1981. The market was hot and the bubble was inflating. A small prick caused the bubble to burst in 1982. One of the banks tried to process a check to find insufficient funds and a bouncing check. The bank quickly rushed to perform the same exercise with other checks to find that many checks bouncing. This triggered a domino effect across the banking sector. The process unveiled more than 6,000 investors with post-dated unsecured checks that were bouncing aggregating as much as $92 billion. It is worth mentioning that USD 86 billion or 94% of the loans were taken by only 308 investors.1 Prices spiraled into the ground, while bids virtually disappeared. To irritate the problem further, oil prices were at only a quarter of what they had been in 1980, stranding the government’s budget.

When analyzing the main causes of the crash we find that the markets were highly speculative due to the high demand on stocks of companies that investors knew very little about. Prevailing issues included:
  1. Exaggerated optimism about the future of companies which reflected in inflated prices.
  2. relation between company information and the buying decision
  3. financing through post-dated checks
  4. a lax attitude towards risk because Kuwaitis though the government would be there to bail them out incase of extreme losses.
  5. Shell companies with weak / no assets
  6. were investing in the market and booking unrealized profits although no profits were received.
  7. No regulation

Within a few days, the crisis had gotten so bad, that it was time for the government to intervene to manage the crisis and control damage. They immediately formed the Kuwait Clearing Co, to register and process all checks involved, and established a KD 500m fund to protect and pay smaller debtors whose investors were bankrupt. In August 1983 the Government urged the settlement of debts at the market price at the time of transaction, and set a maximum premium of 25% on post dated checks. The government bore the brunt of the crisis and was forced to inject large sums into the banking system to restore liquidity. A wave of regulation swept the system restricting listing and halting establishment of new companies.

But the measure the government took wasn’t enough and the negative effect of the crash lingered until 1991.3 The economy was stagnant experiencing a cumulative average growth rate (CAGR) of -30% in real terms over those 9 years. Following widespread bankruptcies, the private sector was grounded and few new companies started up. Loans dried up as the banking sector was reluctant to give out loans. The government finally decided to eliminate the cause once and for all and in late 1991, the government purchased the entire debt load directly associated with the crash, as well as the entire domestic consumer debt load. The rescue package was estimated to cost nearly USD 20 billion including USD 1 billion of consumer debt and USD 3 billion of housing debt. In unison the government addressed accountability issues on the government level and pushed to restore confidence in the market.

Financial Crisis 2008

Today’s financial crisis is not unique to Kuwait. It has been imported from the west to the east, with no one to spare. Although the onslaught may be of international effect, many similarities can nonetheless be drawn between Souk al Manakh and the financial crisis today. Fueled by surging oil prices reaching a peak of USD 140 a barrel, the Kuwaiti economy was booming. Liquidity was abundant and investors were lavish. The Kuwait Stock Exchange was buoyant, peaking at 15,600 points. The market was growing 25% to 40% annually, a great source of easy money. Company information had little correlation with speculators’ investment decisions, as was the case with Al Manakh. High levels of margin were being used to finance purchases, while financers had poor credit control. Consumer credit increased rapidly as did institutional debt. Short term debt, 80% of total debt, was being used to fund long term assets, 74% of total assets, setting up the system for failure.

As a result of the surge in stock prices, many shell companies sprung up and complicated corporate structures were employed. Transparency plunged. Investors’ attitudes were risk tolerant as they thought the government would be there to bail them out in case of a jam and they were speculating with borrowed funds. Then the unexpected occurred. The international markets crashed. Toxic assets ate away profits and confidence while subprime defaults shocked the real economy. Suddenly the capital markets were dried up, and it became near impossible to find financing. Investors realized KSE was unsustainable and prices took a nose dive. Low business confidence paralyzed the market.

At the same time, oil prices plummeted along with government revenue. The government of Kuwait’s response to the crisis lagged and was untimely. The government repeatedly announced the convening of a bailout strategy meeting but no action followed. Upon the government’s inaction, the stock market plummeted further each time. Finally, when the government acted they passed a buyout package which targeted buying up shares on the secondary market. The effect of this was minor and reversed immediately. Gulf bank was propped up, local bank deposits were guaranteed, but debt burdens and the true underlying causes were not addressed though.

Till date, the government has yet to pass the “Stablization Law”, with which they wish to stimulate the economy. The Law will target a stimulus to the banking and investment sectors. The new law will guarantee bank’s toxic assets and new loans issued. The law will also guarantee new loans to the investment sector to allow them to refinance their debt. But the package may be too late for it to be beneficial. Further the Central Bank is not equipped operationally to implement the package, because it must assume control of the governance of investment firms. Companies seeking assistance will lose freedom of governance and usage of resources thereby imposing a management burden on Central Bank.

History repeats itself.
A concern is mounting that government action is inadequate and the economic impact may hinder future economic growth. We wouldn’t like to repeat the same mistakes which caused economic turmoil following Al Manakh crash. The IMF is already expecting Kuwait’s Real GDP to shrink by 1.1% in 2009.2

Previously, it was not until the government purchased distressed debt, that the effect of Al Manakh was completely alleviated. Thus we need to recognize these lessons. We should also learn from the actions of larger economies. The US passed a USD 700 billion bailout plan to buy distressed assets, of which USD 250 billion went to the banking sector. Then in February, a USD 787 billion stimulus was signed, to stimulate the real economy through infrastructure and real projects to alleviate unemployment. Recently the US approved the Public-Private Investment Program (PPIP) worth USD 40 billion to purchase toxic RMBS and CMBS assets. Not all measures taken by the US were 100% successful or effective, but their actions have begun to stimulate the US economy, as seen by improving unemployment figures in recent days. Likewise, the government of Kuwait should learn from this experience. They should follow suite and engage the private sector in a serious effort to tackle the issue, for there is a real risk of an economic stagnation to present itself. Furthermore, the court system in Kuwait needs improvement to ensure the rights of investors, which are currently not 100% ensured.

1 Euro Journal.
2 Markaz research report
3 Kuwait. From reconstruction to Accumulation.

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