The rating agency said the economic legislation - including a privatization law, a four-year development plan, a capital markets law and a labor law - will help the Gulf Arab state diversify its economy.

"Moody's believes that these laws, despite some limitations, should help to develop the country's limited private sector and attract foreign investment," the ratings agency said.

The world's fourth-largest oil exporter is largely dependent on oil revenues and government spending, but it has been on a privatization drive in hope of becoming a regional financial center.

Moody's said Kuwait's fiscal and current account surpluses were "impressive" despite some adverse effects from the recent global financial crisis.

The rating agency said its negative outlook for the country's banking system was mainly due to concerns about the region's investment companies and exposure to commercial real estate and stock market investments.

However, these weaknesses were offset by the "very strong financial position of the government, which can afford to provide substantial support to Kuwait's banking sector in case of systemic difficulties," Moody's said.

The rating agency noted it had "some lingering concerns about institutional strength and government effectiveness."

Kuwait continues to be ranked lower than rating peers according to international governance surveys and it remained to be seen whether the abatement of tensions between the Cabinet and legislature will be sustained, Moody's said.

Tension between Parliament and the government had in recent years triggered numerous cabinet resignations or reshuffles, and delayed legislation.

Meanwhile, the outlook for Bahrain's banking system remains negative, reflecting expectations that challenging credit and business conditions will continue over the medium term.

These expectations are based on the continued weakness in Bahraini and regional real estate and the impact it is having on the rest of the economy, despite the modest rebound in the economy in 2010, Moody's said in its new Banking System Outlook on Bahrain.

The negative outlook is also driven by the ongoing franchise challenges at Bahraini-based wholesale lenders, as they try to refocus their business toward more profitable segments; and secondly by the more severe challenges at investment banks, which in many cases do not possess sufficient franchise depth to cope with the sharply lower private investment activity and depressed regional asset values.

Moody's negative outlook for this sector assumes further deterioration in at least some aspects of Bahraini banks' franchises and risk profiles. The rating agency's primary focus will be on possible further increases in non-performing loans, with banks' significant construction and real-estate exposures being an area of particular concern, the report said.

"Our current assessment is that although real-estate loan quality has generally remained robust so far, continued weakness in this sector will eventually feed through to banks' loan portfolios, both directly and indirectly through loan exposures to other sectors of the economy," said George Chrysaphinis, Moody's analyst and author of the report.

Moody's acknowledges that although systemic banking risk is an issue in Bahrain, in view of the large size of the banking sector relative to the size of the economy, the regulatory authorities have shown that they are able to contain this risk.

"The stability of the system resides in the clear distinction between the retail and wholesale banking sectors and in the Central Bank of Bahrain's (CBB) fairly robust regulatory and supervisory environment," said Chrysaphinis. "There is recognition that the wholesale banking category, which also includes investment banks, carries more risk, but that possible bank failures can be isolated because wholesale banks do not form part of the domestic payments system. In this regard it should be noted that the Bahraini authorities have so far not had to provide any material assistance to the retail banking sector, in contrast to regional peers".