Dimming outlook for Bahrain economy

Low oil prices present further challenges to the stuttering Bahraini economy. Published in The Gulf, March 2015

On 9 February, ratings agency Standard & Poor’s (S&P) downgraded the Bahraini economy, citing its widening fiscal deficit. It will not have come as much of a surprise. Another agency, Fitch Ratings, did something similar in December when it revised its outlook for Bahrain to negative.

The challenges facing Bahrain are varied. It has the smallest economy in the Gulf Co-operation Council (GCC) and the sharp drop in oil prices since last summer have only served to highlight weaknesses.

The country has relatively limited financial resources, with reserves estimated at just $16 billion, and it has been consistently running budget deficits in recent years. Although its oil reserves and output are far smaller than those of its neighbours, the government still relied on oil for almost 87 per cent of its revenues last year.

During the current period of low oil prices the government is bound to earn far less. US bank Citigroup says that, based on an average oil price of $63 this year, it expects Bahrain’s government revenues to fall from $7.6 billion in 2014 to $5.4 billion this year, a drop of 29 per cent.

Benjamin Young, an analyst at S&P, says lower revenues will lead to lower public sector consumption. He also predicts that local companies will make lower profits this year, which in turn is likely to translate into lower credit growth, reduced activity in the financial sector and lower private sector spending.

“We think that the prospects for Bahrain’s economy have weakened and could continue to weaken as a result of the lower oil price environment,” says Young. “Bahrain’s economy has posted robust growth over the past four years, which is a reflection of the economy’s relative diversification compared to regional peers. We think that growth will fall substantially in 2015.”

Just how the economy will be affected depends to a large extent on how oil prices perform over the course of this year and thus what happens to the government’s finances. But it seems inevitable that the government will be forced further into the red this year, even with some expected cuts in spending. S&P estimates that the general government deficit will widen to eight per cent of gross domestic product (GDP) in 2015, compared to 2.1 per cent in 2013 and 3.3 per cent last year.

The government is being helped to some extent by handouts from the richer GCC states. In 2011, $10 billion was pledged over the following decade to help the kingdom address its spending needs. That money is gradually coming through, at the rate of $1 billion a year, and is being directed towards infrastructure projects such as housing, schools and roads.

Even so, the government is expected to trim its spending plans this year to prevent the deficit getting too large. This year’s budget has yet to be published, but S&P says that it expects capital spending levels to be brought back from an average of around six per cent of GDP over the past few years to two per cent this year. Citigroup says it expects overall expenditure to be 11 per cent lower this year than last, dropping to $8.1 billion from $9.1 billion in 2014.

“There is no doubt that the upcoming budget will have to address the current economic climate, though I would not want to speculate ahead of time on possible measures,” says Jarmo Kotilaine, chief economist at the state-owned Economic Development Board (EDB). He adds that “there is also a recognition of the need to continue ongoing efforts to boost public sector efficiency and rationalise expenditure. The overall effect of any budget cuts would depend entirely on what spending was reduced and by how much. Clearly there are means of rationalising government spending that have comparatively less impact on the overall economy.”

Bahrain is, of course, not the only country to be struggling with the low oil price environment. The Washington-based Institute of International Finance estimates that the likes of Iraq, Algeria, Iran and Oman all need oil to be selling well above $100 per barrel to balance the books - known as the breakeven oil price. Even the likes of Abu Dhabi and Saudi Arabia are facing up to budget deficits this year. But that will be little comfort to the policy makers in Manama.

“The six Gulf monarchies are undergoing very profound change when it comes to the structure of their economies,” says Jane Kinninmont, deputy head of the Middle East and North Africa programme at the Chatham House think-tank in London. “The urgency and the timescale of these economic challenges varies from country to country. It’s most pronounced in Oman and in Bahrain, the least oil-rich of the Gulf countries. It’s really no coincidence that those were the countries that saw the greatest unrest at the time of the Arab uprisings.”

As is the case with other Gulf states, the authorities in Bahrain are likely to shy away from any significant cuts to public sector wages, given the risk of stoking further unrest on the island.

The political turmoil has inevitably had an impact on the economy, not least because as it serves to make Bahrain a less attractive place for international companies to do business. These days, executives tend to prefer Abu Dhabi, Doha or Dubai.

Bahrain was once the regional hub for banks and the financial sector remains the second largest part of the economy, accounting for around 17 per cent of GDP, according to the EDB’s most recent annual report. Yet there are fewer banks and insurance companies operating in Bahrain today than in 2009. By some estimates, the banking system has shrunk by as much as a quarter over the past few years.

The system of financial regulation in Bahrain is still well regarded and the country’s banking system also remains well capitalised, which in theory provide a solid foundation for a revival. Some executives in the region have even speculated that Bahrain could reposition itself as a low-cost alternative to Dubai, but it is likely to find that hard to achieve.

“We believe that there is growing momentum behind Dubai’s dominance in regional finance, which has been part of the reason behind the reduction in Bahrain’s banking system’s assets by some 25 per cent since 2008,” says Young. “We believe the already high level of competition in financial services - locally and regionally - will limit the scope for growth at Bahrain’s offshore and retail banks.”

Other areas of the Bahraini economy are also under pressure. Data on the hotel sector from consultancy firm EY show that occupancy rates were below 50 per cent in 2013 and most of 2014, compared to well above 70 per cent in the likes of Dubai and Abu Dhabi. That suggests that Bahrain is struggling to attract both business and holiday travellers.

That impression is further supported by data compiled by the World Travel & Tourism Council. It says the tourist industry directly contributed just $1.3 billion to the Bahrain economy in 2013, the same as in Yemen and well below the level of other Gulf countries.

Having said all that, the economy is still at least growing, even if it appears to be decelerating. The IMF is predicting that Bahrain’s GDP will expand by 3.3 per cent this year and 3.1 per cent next year. Others put the numbers slightly lower. S&P, for example, suggests that growth will average two per cent from 2015 to 2018, while London-based Capital Economics puts the figure at two per cent for this year and 1.5 per cent for next year.

The growth is being led by the non-oil economy, which is due to expand by 3.5 per cent this year and next, according to the IMF’s projections. Another positive element is the fact that inflation is also well under control, with prices rising by around 2.5 per cent a year.

Kotilaine is more optimistic about the country’s growth prospects than most observers. “Both the structural and cyclical growth drivers in the non-oil economy are robust and resilient, not significantly influenced by oil price variations,” he says. “We are projecting non-oil growth of around 4.5 per cent in 2015 and we expect this momentum to continue in the medium to longer term.”

Not everyone has such a sunny outlook, but even if it does struggle, Bahrain does at least have the comfort of knowing that its richer neighbours are likely to continue offering help.

“Bahrain may struggle, but we suspect that [its] larger Gulf neighbours would step in to provide financing if it was needed,” said Jason Tuvey, Middle East economist at Capital Economics, in a research note published in January.