Anyone who has ever been to the Middle East’s smallest country has a stamp in their passport cheerfully welcoming them to ‘business friendly Bahrain’. It is easy to justify its tagline. Bahrain has a relatively diversified economy, a beautifully regulated financial sector, a well-educated work force and low-cost environment.
It also has some very useful friends. Despite the oil sector contributing less than 20 per cent to GDP, fiscal revenues are heavily dependent on oil, and the fall in prices nearly brought the economy to its knees in 2014.
Keen to avoid a financial crisis that could undermine sentiment in the region, in October 2018 Kuwait, Saudi Arabia and the United Arab Emirates stepped in with pledges of $10 billion over the next four years. With the total funds equalling 26 per cent of GDP in 2018, it’s no surprise that Bahrain’s benefactors expect to see something in return for their generosity.
Bahrain has responded with an ambitious package of reforms which aim to eliminate the Kingdom budget deficit by 2022. Rating agencies were suitable impressed, with Moody’s upgrading Bahrain’s outlook to stable from negative and S&P affirming its ‘B+/B’ rating.
“The key driver of the outlook change to stable is Moody’s assessment that Bahrain’s Government and external liquidity risks, while remaining elevated, have materially reduced following the announcement of a $10 billion financial support package from Bahrain’s Gulf Cooperation Council neighbours,” Moody’s said in a statement.
“Financial support and the fiscal consolidation measures that are set to accompany it will support investors’ confidence and help to reduce the government’s financing needs.”
The plan focuses on boosting nonoil revenue, pruning the public sector, slashing expenditures and increasing water and electricity tariffs. The government plans to shrink its public-sector workforce by about 15 per cent through a voluntary retirement scheme, offering early access to end-of-service packages and the opportunity to start a new career in the private sector.
To ramp up revenues, the Fiscal Balance Programme (FBP) details the introduction of a five per cent value added tax, a review of existing government fees and services and the repricing of tariffs charged to domestic industrial consumers of natural gas.
The measures also include setting up new units which will keep an eye on spending, streamline processes and improve transparency across government departments. Internal audit and central government procurement units within the Ministry of Finance, alongside a new debt management office, are also currently in the works.
“The authorities’ Fiscal Balance programme, underpinned by the 2019-20 budget, has provided a commendable framework to arrest the decline in fiscal and external buffers since 2014,” said Bikas Joshi, who led an IMF mission to Bahrain in 2018. “The introduction of a value-added tax in January 2019 is a particularly significant step, as are plans for cost recovery in utilities and further means tested subsidy reforms.”
Taking into account the Government’s new plan, S&P now expects Bahrain’s fiscal imbalance to narrow at a faster pace, reaching five per cent of GDP by 2021 from close to 10 per cent of GDP in 2017. Bahrain has kept the conditions of the loan close to its chest, however it is thought to be tied to the planned reforms.
Moody’s anticipates that funds from the financial support package will be disbursed during 2018-22 in the form of long-term concessionary loans, more than covering the scheduled external debt payments of the Government. These concessionary loans will also support Bahrain’s liquidity position and reduce the risk of the Central Bank’s foreign exchange reserves running dry.
Importantly, Moody’s believes that Bahrain will be able to draw on additional support from its GCC neighbours to maintain the stability of its exchange rate peg during the course of the implementation. Moody’s also expects that the presence of the GCC backstop will allow the Government and government-related entities to regain access to international capital markets, which had become compromised during much of 2018.
“The fiscal reforms announced by the government as part of the would represent very significant fiscal consolidation,” the rating agency said. “While Moody’s expects some implementation hurdles and, as a result, a more gradual fiscal consolidation, some of the measures outlined becoming effective will slow the weakening of Bahrain’s fiscal metrics.”
According to Moody’s calculations, the FBP is aiming to shrink government spending to 19.5 per cent of GDP from 26.6 per cent in 2018 over four years, with an increase in revenue to 19.3 per cent from 17.5 per cent, which would restore budget balance by 2022.
Hydrocarbon production accounted for about 15 per cent of nominal GDP in 2018, implying that Bahrain is less vulnerable to fluctuations in oil prices than the rest of GCC. However, non-oil growth needs a bigger boost before it can protect the economy from the highs and lows of black gold.
Moody’s expects that Bahrain’s non-oil growth will be around three per cent in the next few years, with fiscal consolidation weighing on growth momentum somewhat. “Economic activity was subdued in 2018,” said Joshi.
“Oil output is expected to have declined by 1.2 per cent, while nonoil output growth decelerated to 2.5 per cent, driven by slowdowns in retail, hospitality, and financial services sectors. Continued implementation of GCC funded projects has supported growth in the construction sector.
“Overall growth in 2018 is estimated at 1.8 per cent, with inflation edging up to 2.1 per cent, mainly driven by higher food and transport prices. With higher oil prices, the reduction in utility subsidies, and the new excise taxes, the overall deficit in 2018 fell to 11.7 per cent of GDP, from 14.2 per cent in 2017. Public debt increased to 93 per cent of GDP.
The current account deficit widened to 5.8 per cent, while reserves remained low, covering only about one month of prospective non-oil imports at end 2018.” The Kingdom has highlighted how non-oil revenues have inched upwards.
The Bahrain Economic Development Board (EDB) claims that Bahrain’s annual real GDP growth of 1.6 per cent in the third quarter of 2018 was underpinned by the construction and manufacturing sectors, as well as increased infrastructure spending. Construction has long been a stalwart of Bahrain’s economy, and with a raft of new megaprojects on the horizon it is likely to play an even more prominent role.
Overall, construction increased 6.2 per cent in the first three quarters of 2018. Large projects such as the opening of the Alba Line Six, which now makes the aluminium smelter the largest in the world, and the Bahrain Petroleum Company Modernisation Programme, are just two of the many large-scale infrastructure developments underway in the Kingdom.
Bahrain’s financial sector is another dependable performer. “The banking system remains stable,” said Joshi. “Ongoing efforts at supervisory and regulatory vigilance, and to further enhance the AML/CFT framework, are welcome. Bahrain has been a leader in fintech, promoting opportunities while revising regulations and collaborating with other regulators.”
S&P estimates that Bahrain’s domestic banks have gross assets at 236 per cent of GDP and, on average, banks display high regulatory capital positions. Domestic liquidity remains healthy with an increase in domestic deposits during 2017, coupled with a stable amount of funds from the Government.
Most of the asset price correction has worked its way through the banking system, according to S&P, as shown by the decreasing cost-of-risk of most banks operating in the country. “We do not expect a significant negative impact on the asset quality of the local banking system,” S&P said.
“We also note that the exposure to the construction and real estate segment has stabilised at about 19 per cent of gross loans, though it still stands at a high 35 per cent of commercial loans.” However, with a large number of pocket-sized banks to serve the small bankable population, there is no escaping the fact that Bahrain is overbanked, forcing intense competition and squeezing interest margins.
“High shares of customer deposits, including from local and foreign owners, and limited reliance on external debt, feature prominently in retail banks’ funding profiles,” S&P said. “Excluding the external assets and liabilities of the wholesale sector, Bahrain’s narrow net external asset position would likely turn to a liability position in the region of 30 per cent of current account receipts rather than the creditor position we currently present.”
The best laid plains
While Bahrain’s promises to better the economy, impartial observers have cast a long shadow of doubt over the country’s ability to fully implement its ambitious reforms in such a short space of time.
“Given the challenge of achieving such large and broad fiscal consolidation, and in light of Bahrain’s limited track record of implementing significant fiscal tightening, Moody’s assumes only a partial implementation of the,” the rating agency said.
“While VAT looks likely to be implemented, maintaining some of the planned expenditure cuts over several years will likely be challenging.” Because of this, Bahrain’s new measures are more likely to stem debt rather than obliterate it.
S&P estimates that the Government’s gross debt stock will reach 87 per cent of GDP by 2021, down from earlier projections of 100 per cent of GDP by 2021. “In our view, the high level of debt remains a constraint on the government’s fiscal flexibility,” it said. “We do not expect government debt to reach the legislated debt ceiling, currently at 102 per cent of GDP.
We estimate debt on a net basis at about 60 per cent of GDP in 2018 and forecast net debt at 69 per cent of GDP by 2021.” This means that servicing the Kingdom’s mountainous debts will continue to be a struggle for the cash strapped country.
Bahrain’s gross international reserves are low, covering less than one month’s current account payments and about 40 per cent of the monetary base, according to S&P’s estimates. Bahrain’s reserves stood at $2.6 billion as of September 2018. In the absence of a substantial and sustained net inflow of foreign currency, this level is prone to volatility.
Moody’s expects that reserves will remain in a range that covers only about one to two months of imports of goods and services. While Bahrain’s support package will cover its debt payments, they will not stretch to increase its foreign exchange reserves.
This leaves Bahrain without much of a cushion against economic shocks, including potential declines in oil prices. Because of this, Moody’s expects Bahrain’s external vulnerability to remain very high and its fiscal strength to remain very low.
Nonetheless, a partial implementation of the is better than nothing and will at least make any remaining debt more affordable. Under the assumption of a partial implementation of the, Moody’s expects that debt affordability will remain low, with interest payments to revenue rising slightly, to 21 per cent in 2022 from 19 per cent in 2018.
Even if fully implemented, the alone will not be enough to secure Bahrain’s financial future. Upon leaving ‘businessfriendly Bahrain’, Joshi concluded, “Additional reform efforts, anchored in a more transparent medium-term agenda, will be needed to ensure fiscal sustainability and support the currency peg, which continues to provide a clear and credible monetary anchor.
Further revenue measures, including a direct taxation system such as corporate income tax, could be considered and spending reforms should be designed to protect the most vulnerable. “Sustained structural reforms would help support inclusive growth and further economic diversification.
This requires developing a dynamic private sector, while transforming the role of the Government without sacrificing necessary public services. Targeted education and labour market reforms would help promote opportunities and improve productivity. Efforts to place greater emphasis on vocational education and retraining are welcome, particularly as technology is rapidly changing the nature of work.
Reforms to streamline regulations should further improve efficiency and catalyse private investment. Improving access to financing for small and medium enterprises would invigorate further the private sector’s contribution to the overall economy.”
While Bahrain may be friendly towards business, it perhaps needs to be a little kinder with long-term reforms that will turbocharge the private sector rather short-term measures that will appease the Government’s creditors. When its debts are paid, it will be left with obligations to its citizens and neighbours which the Kingdom’s future prosperity depends upon it fulfilling.