Tuesday 13, June 2017 by Nabilah Annuar

Fitch revises Bahrain's outlook to negative; affirms IDR 'BB+'

Fitch Ratings has revised Bahrain's outlook to negative from stable and affirmed the sovereign's Long Term Foreign- and Local-Currency Issuer Default Ratings (IDR) at 'BB+'.

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 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 local-currency short-term bonds have been affirmed at 'B'.

Bahrain's ratings are supported by high GDP per capita and human development indicators (relative even to the BBB 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.

Beyond various near-term measures to rein in the fiscal deficit, the government has yet to identify a clear medium-term strategy to tackle high deficits and a rapidly growing government debt ratio. The lack of a medium-term fiscal framework, combined with the absence of the two-year budget for 2017 and 2018 six months into the budget period, creates increasing uncertainty around the outlook for debt and deficits.

The government deficit widened to 16.2 per cent of GDP in 2016 from 15.4 per cent in 2015, with subsidy reforms not fully offsetting a decline in oil revenue, and interest costs undermining savings elsewhere on expenditure. Although Fitch expects the deficit to narrow to 10.2 per cent of GDP by 2018, this will be insufficient to stabilise the debt trajectory. Under Fitch's baseline assumptions, which include a moderate rise in oil prices and implementation of fiscal measures already identified, debt will continue to rise, hitting 100 per cent of GDP in 2026 (from 74 per cent of GDP in 2016). Fitch's deficit numbers include estimated extra budgetary spending of 2.6 per cent of GDP. 

In Fitch's view, the slow progress towards the new budget and a medium-term fiscal strategy reflects the difficulty of building consensus over the next wave of fiscal consolidation measures. Reining in the deficit further could call for deeper reforms to Bahrain's social and economic model, traditionally characterised by low taxation and generous benefits. In Fitch's view, the country's leadership is generally committed to reform, but this commitment is not yet shared by other stakeholders, and the government remains wary of social pressures.

Fitch expects hydrocarbon revenue to rise by around 28 per cent and non-hydrocarbon revenue to rise by about 16 per cent in 2017. Gradual increases in administered gas and fuel prices partly offset the negative effect of weak oil prices on hydrocarbon revenue in 2016 and will augment revenue increase this year. The government has already introduced higher fees for various government services and a fee on certain commodities ahead of GCC-wide implementation of an excise tax. The government is working to introduce a VAT in 2018 in line with agreement among GCC states, which could provide a fiscal boost in the region of 2 per cent of GDP, according to IMF estimates. Fitch assumes that this implementation will be delayed from early 2018 into 2H18, given the magnitude of the technical challenges involved. 

Spending was flat in 2016, and Fitch expects it to grow at well below GDP growth in 2017-2018. Subsidy expenditure fell almost 8 per cent in 2016 and a schedule of gradual increases to water and electricity tariffs holds out the promise of a further 4-5 per cent decline per year in the subsidy bill in 2017 and 2018. Capital spending also fell by around 7 per cent and will shrink further as the government's project pipeline is increasingly financed through the GCC Development Fund. The government's nominal wage bill was roughly constant in 2016, with significant government efforts to contain benefits and allowances to its employees offsetting the effect of a 1.5 per cent-3 per cent increase to base salaries. 

Fitch expects real GDP growth of 2.4 per cent per year in 2017-2018. This reflects constant hydrocarbon volumes (after a slight fall in 2016) and a moderation of non-hydrocarbon growth to 3 per cent from an estimated 3.7 per cent in 2016. Spending on projects financed by the USD7.5 billion (20 per cent of GDP) GCC Development Fund provides the most significant support to growth amid government retrenchment. Some USD3.1 billion of projects had been awarded to contractors at end-2016, up from USD1.1 billion at end-2015. Growth is also supported by state-owned enterprise projects (in oil, gas, and aluminium) and strong GCC demand for Bahrain real estate.

Growth of credit to the private sector slowed to an estimated 2.5 per cent in 2016 after 8.8 per cent in 2015. Banks would be well-placed to extend more credit to the economy, given their sound profitability, high capitalisation and liquidity, and low non-performing loan levels. However, deposit growth has slowed and the high yields on government debt make some private sector lending unattractive. As a result, Fitch expects growth of credit to the private sector to stay muted at 2 per cent-3 per cent per year.

The GCC Development Fund reflects the broader support that Bahrain enjoys from some GCC countries, particularly Saudi Arabia and Kuwait. This support is rooted in deep historical, cultural and familial ties as well as regional rivalries. Bahrain gets most of its oil from the Abu Sa'afa field shared with Saudi Arabia (it is entitled to 50 per cent of production, but has sometimes received significantly more as a form of support). In Fitch's view, further material support from the GCC would be forthcoming in case of extreme political, financial, or fiscal instability, given Bahrain's small size and strategic importance. The expectation of such support has helped to maintain Bahrain's market access and US dollar peg despite low foreign exchange reserves, which had fallen to an estimated 1.2 months of current external payments at end-2016.

Fitch expects Bahrain's recent severing of ties with Qatar to have a limited direct dampening effect on growth. Qataris make up slightly more than 1 per cent of inbound arrivals to Bahrain, but loss of flights from Doha and heightened risk perceptions could deter some non-GCC visitors (currently more than a third of the total). Qatar had not been contributing to the GCC Development Fund, but some private real estate investment will likely be forgone. The ban on flights by Qatar Airways could provide an opportunity for state-owned Gulf Air to seize market share on regional routes and reduce reliance on government subsidies.

Tensions continue between the government and the predominantly Shia opposition, resulting in sporadic and isolated incidents of violence and clashes with security forces. Courts have now banned the two main opposition groups, which boycotted the previous election and were charged with fomenting violence and terrorism. Fitch's baseline assumption is that Bahrain's security forces will continue to prevent the sort of escalation of domestic tensions that would materially affect economic growth. However, Fitch believes that the government's recently more hard-line stance increases the risk of instability, notwithstanding a tight security environment and strong regional support.

Fitch's proprietary sovereign rating model (SRM) assigns Bahrain a score equivalent to a rating of 'BB+' on the Long-Term Foreign Currency IDR scale. 

Fitch's sovereign rating committee adjusted the output from the  to arrive at the final Long-Term Foreign Currency IDR by applying its qualitative overlay (QO), relative to rated peers, as follows: external finances: +1 notch, to reflect the boost to external financing flexibility from strong GCC support; public finances: -1 notch, to reflect a rising debt trajectory and the rigidity of government revenue and expenditure.

Fitch's  is the agency's proprietary multiple regression rating model that employs 18 variables based on three year-centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign Currency IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the  output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

The main factors that could lead to negative rating action are: the failure to shrink the fiscal deficit and set out a clear path towards stabilising the government debt-to-GDP ratio; and severe deterioration of the domestic security environment.

The main factors that could lead to positive rating action are: a narrowing of the budget deficit consistent with a decline of the government debt-to-GDP ratio in the medium term; a broadly accepted political solution to domestic political tensions.

In this rating action, Fitch assumes that Brent crude will average USD52.5/bbl in 2017 and USD55/bbl in 2018. The rating agency also assumes no change to the rule of the royal family, that regional conflicts will not directly impact Bahrain or its ability to trade and no change to the peg of the Bahraini dinar to the US dollar.

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