Monday 04, December 2017 by Jessica Combes

Kingdom of Bahrain rating lowered to 'B+' on extremely weak external liquidity


Bahrain's gross international reserves are low and have become more volatile throughout the year, temporarily falling as low as 30 per cent of the monetary base during the third quarter of 2017.

Government access to international capital markets has proven crucial in supporting the central bank's low level of foreign currency reserves.

According to S&P, this increases financing risks should Bahrain's access to external liquidity deteriorate sharply, perhaps due to more limited access to international capital market financing. Bahrain's gross external financing needs are among the highest across rated sovereigns. The long-term foreign and local currency sovereign credit ratings on Bahrain are therefore lowered to 'B+' from 'BB-'.

The outlook is stable because although the central bank may be unable to meet a surge in demand for foreign currency or to temper the effects of a significant worsening in investor sentiment, S&P expects financial support from neighbouring sovereigns would be forthcoming.

Rating Action
On 1 December 2017 S&P Global Ratings lowered its long-term foreign and local currency sovereign credit ratings on the Kingdom of Bahrain to 'B+' from 'BB-'. We also lowered our long-term foreign currency issuer credit ratings on the Central Bank of Bahrain (CBB) to 'B+', in line with our ratings on the sovereign. We affirmed the 'B' short-term foreign and local currency sovereign credit ratings on Bahrain and CBB. The outlook on Bahrain and its central bank is stable. We have also lowered our transfer and convertibility (T&C) assessment on Bahrain to 'BB-' from 'BB'.

The stable outlook reflects risks that the central bank would be unable to meet a surge in demand for foreign currency or to temper the effects of a significant worsening in investor sentiment over the next 12 months, balanced by potential financial support from neighbouring sovereigns.

If Bahrain's net external asset position improves, perhaps due to a significant inflow of foreign currency to the country, or the Bahraini government undertaking additional steps to improve its structural fiscal position, significantly reducing its accumulation of debt, we could consider raising the ratings.

Conversely, if fiscal and external pressures intensify, the coverage of external liabilities by liquid external assets falls more sharply than expected, or if support from neighbouring sovereigns is not forthcoming when needed, we could consider a negative rating action.

The downgrade reflects S&P’s view of the risks related to the low levels and heightened volatility of international reserves at the central bank, should Bahrain experience a sharp deterioration in its access to external liquidity. Gross reserves temporarily fell as low as 30 per cent of the monetary base during the third quarter of 2017. Government access to international capital markets has proven crucial in supporting the CBB's low level of foreign currency reserves. Bahrain's government has not faced any difficulties in issuing Eurobonds, which we believe is partly explained by investor expectation that neighbouring states would provide financial support to Bahrain if needed.

S&P’s ratings on Bahrain are supported by the country's net external asset position and modest level of economic wealth. The ratings are constrained by our view of Bahrain's continued fiscal dependency on oil revenues, its rapid accumulation and high stock of government debt, and its unresolved domestic political tensions, which hamper economic policy effectiveness. The ratings are also limited by the economy's weak performance in real GDP per capita terms.

Flexibility and Performance Profile: Central bank international reserves are very low
Bahrain's external and fiscal metrics remain weak, with gross international reserves covering less than one month's current account payments and about 50 per cent of the monetary base at end-year 2017, according to our estimates. However, reserves coverage fell to a low of 30 per cent in July 2017, with reserve levels reaching historic lows in that month. We expect continued volatility in this ratio throughout the coming years, in the absence of a substantial inflow of foreign currency.

The reason for the volatility in the ratio is that government Eurobond issuance has been the main support for the CBB's gross international reserves in 2017, followed by an average $280 million drain on reserves in the subsequent months. The base level of reserves has been trending lower after each sustained decline before the government issues more bonds.

Gross reserves spiked following the government's $3 billion issuance in September 2017, which was 5x oversubscribed. As a result, reserves increased to $3.7 billion. Reserves are expected to be run down to about $2.5 billion by year-end 2017 and to continue to fall in the subsequent months until the government issues another Eurobond. Projections for central bank gross international reserves are broadly flat over the period to 2020, as we expect the Bahraini authorities to continue this strategy of raising external government debt for fiscal deficit financing purposes, which at the same time supports central bank reserve levels.

It is noted that the government has relatively limited foreign currency spending needs and that this policy further worsens Bahrain's net external asset position. Coverage of external liabilities by liquid external assets (narrow net external debt) is expected to continue falling. Deducting Bahrain's monetary base from reserves–because S&P views currency convertibility into foreign currency as a requisite for pegged arrangements–results in negative usable reserves.

In S&P’s view, monetary policy flexibility is limited because the Bahraini dinar is pegged to the US dollar. In addition, we view the credibility of the CBB to maintain its exchange rate arrangements as weak, given its low and volatile level of reserves.

Increased disbursements from Gulf Cooperation Council (GCC) funds pledged to support the Bahraini economy in 2011 could boost the CBB's reserve position in the short term, but only as long as they are not utilised, for example, to pay for imports in the development of their assigned projects. It is unlikely the $2.5 billion from Qatar will be forthcoming, given regional political tensions, likely reducing the overall amount of GCC funds to $7.5 billion. About $1.4 billion (four per cent) has been disbursed from the funds since 2013, with a sharp increase in disbursements taking place in 2016 ($675 million) and 2017 ($440 million disbursed in the year to October). Further annual disbursements of close to $1 billion over the next six years are expected.

A modest narrowing in Bahrain's current account deficits through the forecast period on the back of the assumption that the Brent oil price will average $55 from 2018 is expected. Fiscal consolidation should support a narrowing in the current account deficit and alleviate the strain on reserves to some extent.

S&P noted that CBB receives daily foreign currency inflows from the sale of oil, through the national oil companies. Daily foreign currency requests from banks to CBB fell by 24 per cent over the first 10 months of 2017, although they increased sharply to average 32 per cent over September and October.

With no indication of lower private sector demand for foreign currency from the domestic economy, weak demand for foreign currency at the central bank could lead to an increase in financial sector external liabilities as banks search for alternative non-resident foreign currency lines to fund domestic assets. This could include lines from Bahrain's large wholesale banking system. S&P could reassess the risk contingent liability wholesale banks pose to the government if the interlinkage between the wholesale banks and the domestic economy were to increase. However, it is unlikely that CBB would act as a lender of last resort for offshore banks.

For S&P’s banking sector contingent liability assessment, the ratings agency referred only to the resident retail banks because the cost of the wholesale banks' potential financial distress would not be fully borne by the government, given the high share of foreign ownership. This is not the case, however, in the external ratio analysis, where the international investment position contains both resident retail and resident wholesale banks.

Despite Bahrain's large financial sector (domestic retail banks) with gross assets estimated at 248 per cent of GDP and a large number of majority-government-owned companies, we consider the government's contingent liabilities to be limited. On average, banks display high regulatory capital positions, and S&P’s Banking Industry Country Risk Assessment for Bahrain is 'seven' on a scale of one to 10, with 'one' being the lowest risk and '10' the highest.

Bahrain's retail banks, the main domestic intermediators, remain healthy in terms of liquidity, capitalisation, and leverage, with a loan-to-deposit ratio of 65 per cent, according to Banking Industry Country Risk Assessment: Bahrain. Asset quality is on an improving trend, but the system wide nonperforming loan ratio is still in the high single digits according to S&P’s estimation and some large banks carry high amounts of restructured exposures.

The wholesale banking sector, Bahraini and non-Bahraini registered, has about 10 per cent of its total assets in Bahrain, but as a proportion of Bahraini GDP these exposures represent just over 30 per cent. It is understood that most of these exposures are funded by domestic liabilities and are to large industrial exporters, but also reflect interbank lending. 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 20 per cent of current account receipts, rather than the creditor position S&P currently presents.

Bahrain's fiscal imbalances are expected to moderate, from close to 12 per cent of GDP in 2017 to 7.5 per cent by 2020. The government has introduced numerous measures since 2015 to control public finances in response to a revenue side shock. Total expenditures should be broadly flat in 2017, compared with the previous year, versus seven per cent average annual growth over 2012-2014.

The main contributor to this has been the reduction of sometimes politically sensitive subsidies and transfers, which have been reduced to about 25 per cent of total expenditures from 29 per cent in 2014. Still, in nominal terms, the burden of consolidation in S&P’s forecasts falls on the revenue side, and incorporates our increasing oil price assumptions and also the introduction of value-added tax (VAT).

It is likely that VAT will have an impact of 1.8 per cent of GDP–three per cent of nominal consumption. The agreed amount is five per cent, and will be introduced over 2018 and 2019. The rationale behind doing this lies with an uncertainty over the timing of its introduction, which is scheduled for 2018. If fully implemented in 2018, this would imply a greater reduction in the fiscal deficit.

S&P has increased its projections for the level of the government's debt stock to include an additional one per cent of GDP in annual debt accumulation, in relation to the government's historical off-budget spending on defence and the Royal Court. We project the government's debt stock to increase toward 100 per cent of GDP by 2020, or above 70 per cent on a net basis.

This level of debt is viewed as a constraint on fiscal flexibility. Currently the government has a legislated debt ceiling of about 102 per cent of GDP. Government debt issuance to September 2017 was 80 per cent external, foreign currency debt, against a prior expectation of a broadly 50-50 split between external and domestic debt issuance. To derive net government debt, S&P has net off cash and available-for-sale securities at the social security system, the National Oil and Gas Authority (NOGA), Mumtalakat (the government holding company), and the Future Generations Fund from gross debt.

Despite Bahrain's low level of reserves at the central bank, its economy and financial system continue to perform relatively strongly. The economy expanded by 3.4 per cent on average over the first half of the year and we have revised upward our GDP growth forecast to three per cent from two per cent as a result.

This reflects Bahrain's relatively diversified economy, proximity to the large market of Saudi Arabia, its strong regulatory oversight of the financial sector, a relatively well-educated workforce, and its low-cost environment. Bahrain's population growth has continued apace (three to four per cent per year); when GDP growth is adjusted for population levels, the real growth rate is negative, suggesting that labour supply is a key driver of growth.

Instances of political violence and street protests increased in 2017 and S&P views the overall security environment in Bahrain as tense, illustrating the entrenched polarisation between the Shia and Sunni communities, and internal communal divisions. The implementation of sensitive fiscal austerity measures has the potential to stoke unrest, thereby constraining the government's policy choices. However, S&P noted that fiscal consolidation measures already introduced have not had any security-related repercussions. Bahrain's political tensions are anticipated to continue, with the potential for security incidents to occur. Given these sensitivities, the overall transparency of policy-making is also constrained and accompanied by variable disclosure of information, according to S&P.

Bahrain is also a member of the coalition of Arab states, which has imposed a boycott on Qatar, cutting diplomatic ties as well as trade and transport links with the country on 5 June 2017. The impact of the boycott may not be confined to within Qatar's borders and S&P expects political tensions within the GCC countries to persist over the next few years.

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