Riding out the storm
Bahrain is still in a sticky situation with continuing deficits, depleting reserves and higher currency risk, but a strong financial sector and GCC support is expected to mitigate the situation.
Bahrain is one of the GCC countries that was hit hard by the drop in oil prices. With its government budget still highly dependent on oil revenues, the Kingdom urgently needs a sizable fiscal adjustment to restore financial sustainability, reduce vulnerabilities, and boost investor and consumer confidence. Bahrain made positive strides in economic diversification by increasing the role of financial services and food processing. According to Moody’s, the proportion of oil exports fell from close to 80 per cent in 2011 to 62 per cent in 2014 and is projected at 44 per cent in 2017, though lower oil imports also contributed to the $5.6 per barrel drop in the external breakeven oil price since 2014. Nonetheless, Bahrain still has the highest external breakeven oil price after Oman, at $69.9 per barrel, due to large import bills and lower overall export competitiveness.
Fiscal and economic condition
“During 2016, economic activity was solid and inflation remained subdued. Overall GDP growth is estimated at three per cent, with strong non-oil growth of 3.7 per cent aided by the implementation of GCC-funded projects. Despite significant fiscal measures that were implemented, lower oil prices led to the overall fiscal deficit and public debt in 2016 near 18 per cent and 82 per cent of GDP, respectively. The external current account deficit is estimated at 4.7 per cent of GDP,” said Padamja Khandelwal, IMF Mission Chief to Bahrain.
Based on current levels of reserves and assuming stable and low oil prices at $50 per barrel, stable oil production, no further economic and fiscal reforms, Bahrain would only be able to sustain the projected 2017 current account deficit for around four years.
According to the IMF, Bahrain’s overall growth has been projected at 2.3 per cent in 2017, continuing to be driven by strong infrastructure spending from GCC funds. Inflation levels in the Kingdom is expected to stay moderate. Owing to the higher expected oil prices and continued implementation of measures to reduce spending and raise non-oil revenues, the fiscal deficit is expected to fall to 12.6 per cent of GDP in 2017 and remain close to that level over the medium term. Furthermore a substantial increase in debt is also projected.
Fitch Ratings expects Bahrain’s GDP growth of 2.4 per cent in 2017-2018 to be driven by constant hydrocarbon volumes (after a fall in 2016) and a moderation of non-hydrocarbon growth to three per cent from an estimated 3.4 per cent in 2016. Spending on projects financed by the $7.5 billion GCC development fund provides crucial support to growth amid government retrenchment. $3.9 billion of projects had been awarded to contractors as at end-2016 up from $1.1 billion at end-2015. Growth is also supported by state-owned enterprise projects (in oil, gas, and aluminium).
Designed to minimise the adverse impact on vulnerable groups, a substantial fiscal adjustment is pertinent. In this context, fiscal measures in the near term could include the VAT, which is already agreed at the GCC level, and further rationalising spending on subsidies, which disproportionately benefit the wealthy, and social transfers. The wage bill, which is nearly 12 per cent of GDP and among the highest in the GCC, can be reduced in the near term by streamlining allowances and freezing nominal wages, suggested the IMF.
Fitch expects the fiscal deficit to fall only moderately to 12.3 per cent of GDP in 2017 (assuming Brent averages $45/bbl), from an estimated 13.6 per cent of GDP in 2016 and 15.4 per cent of GDP in 2015. The estimated fiscal breakeven Brent oil price of $84/bbl for 2017 is well above expected oil prices in the medium term. Continued deficits will push debt to 84 per cent of GDP in 2018 from 75 per cent of GDP in 2016 (well in excess of the BB median of 51 per cent of GDP). Fitch's deficit numbers include estimated extra-budgetary spending of 2.6 per cent of GDP, and the 2016 fiscal outturns are still preliminary.
Subsidy reform, spending restraint and growing non-oil revenue underpin the adjustment effort. Gradual increases in domestic gas and fuel prices partly offset the negative effect of oil price weakness on hydrocarbon revenue, which Fitch expects to rise 13.4 per cent in 2017 after a fall of only 10 per cent in 2016. Fitch expects spending to grow at a rate below non-oil GDP growth, after a broad-based cut of 8.2 per cent in 2016.
Over the medium term, sizable further consolidation can be achieved in the context of a civil service review and will help support the goal of boosting private sector employment of Bahraini nationals. The IMF mission in its concluding statement further added that other measures are also needed to raise non-oil revenue to help finance the provision of government services. This includes reforms to strengthen the fiscal framework that would support the process of fiscal consolidation.
Bahrain is expected to finance its deficits through a mixture of foreign and local debt. Fitch forecasts government foreign borrowings to reach about $3.2 billion in 2017 and $2.2 billion in 2018, after $2.9 billion in 2016. Fitch assumes domestic borrowing to be less than a third of these amounts, in line with 2016. A debt management strategy is still in the early stages of development, but the government wishes to limit domestic borrowing.
The government would have recourse to other means of financing should a stressful situation arise. Its deposits in domestic banks (around 14.2 per cent of GDP in 2016) mostly reflect the assets of the Social Insurance Organisation, which could increase its holdings of government debt. Government-owned Mumtalakat Holding Company has an illiquid portfolio of mostly domestic assets with a balance sheet value of around 30 per cent of GDP.
Additionally, the GCC development fund reflects the broader support that Bahrain enjoys from some GCC countries, particularly Saudi Arabia and Kuwait. Further material support from the GCC is highly likely in case of extreme political, financial, or fiscal instability, given Bahrain's small size and strategic importance.
Increasing currency risk
Currency risks across the GCC are relatively low. However this is not the case for Bahrain. Moody’s in a recent commentary pointed out that pressures are building in Bahrain because of low foreign exchange (FX) reserves.
The country's foreign-exchange reserves halved to $1.5 billion (a little over one month's worth of imports) between December 2015 and September 2016, before bouncing back to $2.7 billion in October. This is despite support funding made available to the Kingdom. The total value of projects initiated under the GCC Fund more than doubled in 2016 to $3.1 billion, while the value of projects that went to tender rose 20.5 per cent to $4.3 billion. Consequently, the aggregate value of active projects should continue to expand significantly in the course of 2017 as work on these ventures begins.
The aggregate buffer to protect the peg is substantial, but reserves are very low in Bahrain. According to Moody’s, the Kingdom’s external debt levels are extremely high at around 147 per cent of GDP. At the same time, its financial buffers are insufficient to cover its short-term external debt and amortisation payments, resulting in a projected External Vulnerability Indicator (EVI) exceeding 1,500 per cent in 2017. A figure of less than 100 per cent for the EVI denotes sufficient resources to cover upcoming external repayments. Unlike other GCC countries, Bahrain is not known to have reserves outside of the central bank.
Strength in banking and finance
Banks are well placed to extend more credit to the economy and the government, enjoying profitability, high levels of capitalisation and liquidity, and low nonperforming loan levels. Higher policy rates and yields on government bonds have not yet translated into significantly higher private sector borrowing costs. Fitch expects credit to the private sector to expand by four to five per cent per year in 2017-18, from an estimated 3.5 per cent in 2016.
“Bahraini banks’ strong capitalisation and liquidity will help them weather a slowing in the pace of economic growth. The Central Bank of Bahrain continues to strengthen its regulation and supervision of the financial sector, which will support the continued development and stability of the financial system. The exchange rate peg to the US dollar continues to serve Bahrain well, and will be supported by fiscal consolidation. Measures to reduce the costs of doing business are key to boosting growth prospects and achieving economic diversification in Bahrain. They can help raise productivity and catalyse private investment, thereby contributing to create better paying private sector jobs for nationals and diversify the economy,” Khandelwal added.
Additionally, to support the country’s growing financial sector, Bahrain became the first country in the GCC to introduce an Investment Limited Partnership (ILP) law. The new move allows investors to establish limited partnerships nationwide, as oppose to only in identified free zones. The law offers new financing structures that complement the existing opportunities available in the Kingdom. It is expected to provide a strong boost to the financial sector, supporting growth in real estate funds, private equity funds, venture capital and technology funds, start-ups, and Shari'ah-compliant funds, as well as captive insurance.
Fitch Ratings in February affirmed Bahrain's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'BB+' with a stable outlook. The country ceiling has been affirmed at 'BBB+' and the Short-Term Foreign and Local Currency IDRs at 'B'. The issue ratings on Bahrain's senior unsecured foreign and local currency long-term bonds have been affirmed at 'BB+'. The ratings on the Sukuk trust certificates issued by CBB International Sukuk Company 5 have also been affirmed at 'BB+'. The issue ratings on Bahrain's senior unsecured local currency short-term bonds have been affirmed at 'B'.
According to Fitch, Bahrain's ratings are supported by high GDP per capita and human development indicators (relative to the BB median), a developed financial sector and the boost to external financing flexibility from strong GCC support. The strengths are balanced by double-digit fiscal deficits, high and rising debt, a highly oil-dependent government budget and domestic political tensions that hamper fiscal adjustment.
The main factors that could lead to positive rating action include a reduction in the budget deficit consistent with a decline of the government debt-to-GDP ratio in the medium term, and a broadly accepted political solution to domestic political tensions. On the other hand reasons that could warrant a negative rating action would be the failure to reduce the fiscal deficit leading to a sharper than expected rise in the debt-to-GDP ratio, as well as a severe deterioration of the domestic security situation.