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Kuwait Financial Centre “Markaz” RESEARCH

March 2008

The Vicious “Square” Monetary Policy Options for Kuwait Monetary authorities in Kuwait (or for that matter in the Gulf) have never been challenged as much as they are now. The monetary policy is surrounded by various factors, what we call as the vicious square, all exerting diverse influence. (Appendix: 1). 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

I N T E R E S T

R A T E S

Kuwait Monetry Policy

I N F L A T I O N

CURRENCY

Inflation: Recent data on inflation points to a surge caused by both domestic (rent, etc) and imported (food, etc). The challenge is to control the inflation through direct and indirect method. Traditional tools like interest rate is providing counter-productive due to currency peg. It is interesting to note that Saudi Arabia has implemented a number of measures recently to combat inflation. (Appendix: 2) Markaz Research is available on Bloomberg. Type “MRKZ” <Go>

Currency: The currency peg has led to imported inflation. This is also forcing the authorities to follow monetary policy actions of US, which is completely divorced from that of local economy. While US is on an easing mode in order to ward off recession, GCC economies are experiencing high growth and inflation which necessitates tight monetary policy. The challenge is to allow for a gradual appreciation of the currency without giving in to speculators.

Interest Rates: US monetary policy action is causing the repo rate to drift lower. However, the discount rate (benchmark for lending rate) continues to be high leading to higher spread. The challenge is to contain this spread M.R. Raghu CFA, FRM without stoking inflation. The current spread is at 2.25% and is the historic Head of Research high. We expect this spread to widen further to 2.5% by end-2008. This is +965 224 8280 rmandagolathur@markaz.com based on the expected evolution of Fed Fund rate for the year end 2008. We expect the discount rate to contract by 75 bps to 5% from the present 5.75%. We expect the repo rate to contract 100 bps from 3.5% to 2.5%. Kuwait Financial Centre “Markaz” P.O. Box 23444, Safat 13095, Kuwait Tel: +965 224 8000 Fax: +965 242 5828 www.markaz.com


RESEARCH March 2008 1. LIQUIDITY Table 1: Liquidity Total Deposits

Deposits grew at a CAGR of 17%, and credit at a CAGR of 21% during the last six years.

KD Million 2001

Total Loans KD Million

Change

10,608

Loan/Deposit Ratio Change

6,851

65%

2002

11,534

9%

7,808

14%

68%

2003

12,150

5%

9,481

21%

78%

2004

13,587

12%

10,814

14%

80%

2005

16,243

20%

12,936

20%

80%

2006

20,174

24%

16,148

25%

80%

2007

26,544

32%

21,821

35%

82%

CAGR* 17% 21% Source: Central Bank of Kuwait & Markaz Research * Refers to compounded annual growth rate

At the heart of the monetary policy is the issue of liquidity. 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%. (Table 1). 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 (Figure 1). Average spreads since 2001 is 337 basis points. For a long time (May 02Jan 06), these spreads used to be more than the deposit rates! Figure 1: Banking Spreads

Spread between lending and deposit rate continues to be high

10 9 8 7

%

6 5 4 3 2 1

Spread(Loans-Deposits)

Dec-07

Jun-07

Sep-07

Dec-06

Mar-07

Jun-06

Sep-06

Dec-05

Mar-06

Jun-05

Sep-05

Dec-04

Mar-05

Jun-04

Sep-04

Dec-03

Mar-04

Jun-03

Sep-03

Dec-02

Mar-03

Jun-02

Sep-02

Mar-02

Sep-01

Dec-01

0

Weighted Interest on Deposits

Weighted Interest on Loans

Source: CBK & Markaz Research

Monetary Policy Options: Either the loan to deposit ratio of 80% should be increased or the discount rate should be increased or try other sterilization measures. Kuwait Financial Centre â&#x20AC;&#x153;Markazâ&#x20AC;?

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RESEARCH March 2008 2. INFLATION

INFLATION

Inflation is a product of both domestic and imported inflation.

Domestic

Imported

Government Spending

Credit Growth

Currency Peg

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. Monetary authorities 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 (Appendix 2). 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.

Total Deposits (LHS)

Sep-07

Mar-07

Sep-06

Mar-06

Sep-05

Mar-05

Sep-04

Mar-04

Sep-03

Mar-03

Sep-02

Mar-02

Tot al Loans (LHS)

CPI

120 115 110 105 100 95 90

30000 25000 20000 15000 10000 5000 0 Sep-01

Inflation may not be a temporary problem

KD Million

Figure 2: Inflation & Liquidity

CPI (RHS)

Source: CBK & Markaz Research

Monetary Policy Options: In order to reign in inflation, the following options are available: 1. Control credit growth on the lines suggested in the earlier section through increase in interest rate 2. Reduce government spending: Reducing government spending will mean actions like reducing work force or reducing salary, which may not be a move well received by the general public. 3. Allow currency to appreciate which is already happening Kuwait Financial Centre â&#x20AC;&#x153;Markazâ&#x20AC;?

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RESEARCH March 2008 3. CURRENCY Figure-3 Currency Movements

120 110

Dollar slide is imposing high cost to Kuwait economy

100 90 80 70 60

Pound Sterling

Swiss Francs

Japanese Yen

Jul-07

Oct-07

Apr-07

Jan-07

Jul-06

Euro

Oct-06

Apr-06

Jan-06

Jul-05

Oct-05

Apr-05

Jan-05

Jul-04

Oct-04

Apr-04

Jan-04

Jul-03

Oct-03

Apr-03

Jan-03

Jul-02

Oct-02

Apr-02

Jan-02

Jul-01

Oct-01

Apr-01

Jan-01

50

Kuwaiti Dinar (Fils)

Source: CBK & Markaz Research

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 (Figure-3 Table-2).

Currency peg is more for political reason than economic reason

Table 2: Currency Movement Pound Swiss Japanese $1 fetched Sterling Francs Yen Euro 2001 0.696 1.668 132.690 1.131 2007 0.493 1.137 112.020 0.685 Change -29% -32% -16% -39% Source: Central Bank of Kuwait and Markaz Analysis

Kuwaiti Dinars 307.483 274.215 -11%

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. Monetary Policy Options: In the currency context, having already depegged from the dollar, the option would now be to narrow the gap by a one-off revaluation followed by allowing Kuwaiti dinar to gradually appreciate albeit in a measured manner in order to deter currency speculators. Gradual Kuwaiti dinar appreciation will ease the pressure on monetary policy.

Kuwait Financial Centre â&#x20AC;&#x153;Markazâ&#x20AC;?

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RESEARCH March 2008 4. INTEREST RATES Given the diversity of terminologies used in this space, Annexure-3 provides an explanation of what these terms mean. Figure 4: Kuwait Central Bank Rates

7

Spread between discount rate and repo rate at its historic high

6 5 4 3 2 1 0

Dec-07

Jun-07

Sep-07

Dec-06

Repo Rate-B

Mar-07

Jun-06

Sep-06

Dec-05

Mar-06

Jun-05

Sep-05

Mar-05

Sep-04

Discount Rate-A

Dec-04

Jun-04

Dec-03

Mar-04

Jun-03

Sep-03

Dec-02

Spread (A-B)

Mar-03

Jun-02

Sep-02

Mar-02

Sep-01

Dec-01

-1

Fed Rate-C

Source: CBK & Markaz Research

Deposit Rate Spreads (KD-US)

2

1-Week KD

1-Month KD

6-Month KD

12-Month KD

1.5

3-Month KD

Figure-5

1 0.5 0 -0.5 -1 -1.5 -2

Ja n0 Ap 1 r01 Ju l0 O 1 ct -0 Ja 1 n0 Ap 2 r0 Ju 2 l0 O 2 ct -0 Ja 2 n0 Ap 3 r0 Ju 3 l0 O 3 ct -0 Ja 3 n0 Ap 4 r0 Ju 4 l0 O 4 ct -0 Ja 4 n0 Ap 5 r05 Ju l0 O 5 ct -0 Ja 5 n0 Ap 6 r06 Ju l0 O 6 ct -0 Ja 6 n0 Ap 7 r0 Ju 7 l0 O 7 ct -0 7

Reduction in discount rate will stoke inflation

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) (Figure 4). 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!

Source: CBK & Markaz Research

Kuwait Financial Centre “Markaz”

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RESEARCH March 2008 The spread between KD deposit rate and US deposit rate has been narrowing, especially on the shorter maturities (3-months and lower) (Figure-5). 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. We expect the spread to continue to be narrow at the short end of the maturity spectrum. Table 3: Kuwait Interest Rates: Monetary Policy Options

We expect discount rate to narrow to 5% by the end of 2008

Dec-04 Dec-05 Dec-06 Dec-07 Jan-08 Feb-08 18–March2008 29/30-April - 2008 24/25– June-2008 5–August2008 16– September2008 28/29– October2008 16December2008

Kuwait Discount Rate-A 4.75 6 6.25 6.25 5.75 5.75

Kuwait Repo Rate-B 3.75 5.12 5.87 4.5 4 3.5

Spread (DiscountRepo)(A-B) 1 0.88 0.38 1.75 1.75 2.25

Fed Rate-C 2.25 4.25 5.25 4.25 3.50 3.00

Fed Change 1 2 1 -1 -0.75 -0.5

Repo Change 0 1.37 0.75 -1.37 -0.5 -0.5

5.75

3.5

2.25

3.00

0

0

5.75

3.25

2.5

2.75

-0.25

-0.25

5.5

3

2.5

2.50

-0.25

-0.25

5.5

2.75

2.75

2.25

-0.25

-0.25

5.5

2.75

2.75

2.25

0

0

5

2.5

2.5

2.00

-0.25

-0.25

5

2.5

2.5

2.00

0

0

Source: Markaz Research. The shaded portion refers to FOMC dates .The boxed number

refers to average forecast of Fed Fund rate by Goldman Sachs, Citibank, Economist, CLSA & Merrill Lynch

We expect the discount rate to narrow by 75 bps to 5% by the year end. We also expect the repo rate to contract by 100 bps (Table 3). 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. Monetary Policy Options: In the interest rate context, the following policy options are available: 1. Reduce the discount rate: A moderate reduction in the discount rate will enable to contain the growing spread. It will definitely spur credit growth (and therefore inflation), which can be contained through reserve requirement and moral suasion. 2. Increase the Repo rate: This will mean moving against the Fed. It will be deflationary but will encourage currency speculation.

Kuwait Financial Centre “Markaz”

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RESEARCH March 2008 5. SUMMARY CHALLENGE LIQUIDITY

INFLATION

CURRENCY

INTEREST RATES

Leverage trading may not be profitable

MONETARY POLICY OPTIONS

RATIONALE

Increasing the discount rate will further increase the spread between the discount rate and repo rate. Sterilizing measures have been less successful in the past. Reducing government 1. Increase interest rate spending may be anti2. Reduce government populist measure. spending Increasing interest rate 3. Continue to allow may be counter to Fed currency to appreciate move. 1. Revalue the dinar Revaluing on a one-off 2 Continue to allow basis may be seen as Kuwaiti dinar to giving in to speculators. gradually appreciate. Increasing repo rate will 1. Reduce the discount be counter to Fed move rate and may encourage 2. Increase the Repo rate speculators. 1. Increase deposit to loan ratio from 120% to a higher level 2. Increase discount rate 3. Sterilize excess liquidity

In our assessment, 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.

Kuwait Financial Centre â&#x20AC;&#x153;Markazâ&#x20AC;?

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RESEARCH March 2008 Appendix 1: The Complex Web

High Oil Price

High Economic Growth

H igh C a pit a l a nd R e v e nue S pe nding H igh Inv e s t m e nt

Higher Interest Rates Lower Interest Rates

I NR TA E T R E E S S T

High Credit Growth

Increase in Foreign Labor

LIQUIDITY

Demand for Goods and Services

Kuwait Monetry Policy

I N F L A T I O N

Domestic Inflation Imported Inflation

CURRENCY

Currency Peg to USD/Basket

US $ Depreciation

US Deficits

Low Economic Growth

Source: Markaz Analysis

Kuwait Financial Centre “Markaz”

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RESEARCH March 2008 Appendix 2: Tackling Inflation- Case Study of Saudi Arabia Saudi Arabia experienced a sharp rise in its inflation. From a modest 0.2% in 2002, the current inflation stands at 4.1%. The Kingdom has implemented a number of measures to control inflation, some of which are re-produced below: 1. Salary Increase: The government will add an annual 5% cost of living allowance to the salaries of its employees and retirees for a period of three years. This salary hike comes on the back of a 15% rise that was given in October 2005 and came on the back of a twenty year pay-freeze. Public sector wages have been on the rise in other GCC countries as well. For e.g., Oman and Bahrain (+15%) and UAE (+70%). 2. Reduction in Port Fees: The government will bear for a period of three years, 50% of all port fees levied. This is aimed to reduce the import cost of goods. 3. Increase in Social Insurance: The government will increase social insurance benefits by 10% which will benefit more than 600,000 Saudis. 4. Fees for passports, etc: The government will bear, for a period of three years, 50% of the fees relating to passports, vehicle licenses and ownership transfers and renewal of residence permits for domestic workers. The current charges are: Services

SR

Issuing Passport

300

Transferring Vehicle ownership

150

Renewing residence permit

600

Renewing car license

300

Rental car license

400

Pick-up van licenses

750

Truck license

1,100

Source: Saudi British Bank Research

Kuwait Financial Centre â&#x20AC;&#x153;Markazâ&#x20AC;?

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RESEARCH March 2008 Appendix 3: Interest Rate Terminologies Terminology

What it means?

Repo Rate

It is the rate at which Central banks re purchase government securities from commercial banks. It is aligned with Fed rate due to currency peg.

Reverse Repo Rate

Same thing from a borrowers perspective

Discount Rate

It is the interest rate charged to commercial banks for loans from the central bank.. Hence, discount rate is a benchmark for lending rate.

Weighted average rate on deposits

Weighted average rate of loans

This is the actual rates offered by banks to customers (weighted by maturity). This may or may not have relation with repo rate. This is the rate at which banks lend to its customers (weighted by maturity). Banks are allowed to charge from 250 bps to 400 bps over discount rate, depending on maturity.

How is it used? A decrease in repo rate will increase money supply and vice-versa

An increase in discount rate will reduce credit growth and vice-versa

An increase in the rate will increase money supply and vice-versa

An increase in the rate will reduce credit growth.

Fed Rate

The rate at which banks lend balances at the Federal Reserve to other institutions

It is used to regulate money supply in US

Libor

Is a daily reference rate based on interest rates at which banks offer to lend to other banks in London inter bank market

Libor is not fixed before hand like Fed rate. Hence, it has no macro economic ramifications

Source: Wikipedia and Markaz Analysis

Kuwait Financial Centre â&#x20AC;&#x153;Markazâ&#x20AC;?

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RESEARCH March 2008

Disclaimer

This report has been prepared and issued by Kuwait Financial Centre S.A.K (Markaz), which is regulated by the Central Bank of Kuwait. The report is intended to be circulated for general information only and should not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable but no representation or warranty, expressed or implied, is made that such information and data is accurate or complete, and therefore should not be relied upon as such. Opinions, estimates and projections in this report constitute the current judgment of the author as of the date of this report. They do not necessarily reflect the opinion of Markaz and are subject to change without notice. Markaz has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on the subject company is withdrawn. This report does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors are urged to seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and to understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securityâ&#x20AC;&#x2122;s price or value may rise or fall. Investors should be able and willing to accept a total or partial loss of their investment. Accordingly, investors may receive back less than originally invested. Past performance is historical and is not necessarily indicative of future performance. Kuwait Financial Centre S.A.K (Markaz) does and seeks to do business, including investment banking deals, with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.

Kuwait Financial Centre â&#x20AC;&#x153;Markazâ&#x20AC;?

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Kuwait Financial Centre “Markaz” RESEARCH

Markaz Research Offerings Strategic research Title

Release Date

Quantitative Research

Sector Research

Research Highlights

Title

Release Date

Title

Release Date

Research Highlights

Since May 07 (Monthly)

Asset allocation strategy for GCC stock markets using an inhouse proprietary model.

GCC Equity Funds: The Asset Allocation Challenge

Sep-06

Issues behind asset allocation for GCC equity funds.

Syria Real Estate

Apr-07

GCC Asset Allocation

GCC Leverage Risk: How real it is?

Nov-06

Examining the risk behind increased exposure of the GCC financial system to stock market.

Saudi Arabia Real Estate

Jul-07

Markaz Volatility Indices (MVX)

GCC for fundamentalists: A top-down framework

Dec-06

Qatar Real Estate

Sep-07

Lebanon Real Estate

Dec-07

Managing GCC Volatility: Strategies and Tactics Derivatives Market in GCC: Cutting a (very) long market short

Feb-07

Establishing a framework involving fundamental variables affecting GCC stock markets. Devising risk-based portfolio strategy.

Mar-07

Examining the need for derivatives market in GCC.

To Leap or To Lag: Choices before GCC Regulators

Apr-07

Examining the evolution and progress of GCC capital market structures.

A Gulf Emerging Portfolio: And Why Not?

Jun-07

A Study on Saudi, Kuwait, and UAE for Portfolio Enhancement.

A Potential USD 140 Bn Industry Review of Asset Management Industry in Kuwait

Sep-07

China and India: Too Much Too Fast GCC more than a global soother

Oct-07

Kuwait: The New law to slash tax

Dec-07

Outlook 2008: Kuwait

Jan-08

Outlook 2008: Saudi Arabia

Jan-08

Outlook 2008: UAE

Jan-08

Outlook 2008: Qatar Emerging Investments trend for 2008 GCC Outlook 2008

Jan-08

Examining the status of Kuwait investment industry, both managed accounts and mutual funds. Run up in China & India is too fast and is a cause of concern. The report suggests inclusion of GCC markets in the portfolio as a soother. A key obstacle to foreign investment has been removed on December 26th, 2007. Stock selection will be challenging. Expect Consolidation Earnings growth momentum to continue Stick to heavy weights

Jan-08

A panel discussion

Jan-08

The “Life Boat” to hang on

Since Jul – 07 (Monthly)

Newsletters Daily Morning Brief KSE Market Weekly Snapshot KSE Weekly Review (Technical Analysis) Weekly Private Equity Update Weekly International Market Update

Launch of Volatility Index for the six GCC markets, EM and S&P.

Markaz Research is available on Bloomberg. Type “MRKZ” <GO> To obtain a print copy, kindly contact: Kuwait Financial Centre “Markaz” Client Relations and Media & Communications Department Tel: +965 224 8000 Ext. 1804 Fax: +965 2414499 Postal Address: P.O. Box 23444, Safat, 13095, State of Kuwait Email: info@markaz.com www.markaz.com


The Vicious Square Markaz Research