Bahrain - Making Sense of the Country's Current Woes

1. Bahrain – Making Sense of the Country’s Current Woes*
ahrain has been under the market spotlight over the past few months as long-
standing concerns over the country’s fiscal and economic standing have once
again mounted. These strains, in turn, culminated in a sharp widening in the
country’s CDS spreads, which topped 600bps in late June. Similarly, Bahrain's dinar
fell to a 17-year low against the US dollar in the spot market on Tuesday, June 26, as
investors sold the currency in the forward market citing concerns over the country's
ability to repay its rising public debt, which the IMF expects to hit almost 95% of GDP
in 2018.
Against this backdrop, the fact that Saudi Arabia, Kuwait and the UAE stepped forward
to announce that they are working on an integrated programme to support Bahrain's
economic reforms and financial stability, did not come as too much of a surprise.
Indeed, the announcement calmed the markets, but downside risks to Bahrain’s
outlook continue to persist while the wait for a formal bailout continues.
1. Context – How did Bahrain get here?
While Bahrain has sought to diversify its economy over the years, it still remains
heavily dependent on the oil & gas sector for a large chunk of its total tax revenues
(~75%). In this context, the sharp drop in oil prices from 2014 onwards severely
impacted Bahrain’s public finances, resulting in a wider fiscal and current account
deficit and a rise in the country’s public debt levels. It also triggered a ratings
downgrade by the three main agencies in 2016/17. Although Bahrain was not alone in
this regard, its sensitivity to falling oil prices is clear to see from the fact that its fiscal
breakeven oil price is much higher than some of its OPEC peers (see chart).
Additionally, compared to its GCC peers, Bahrain’s fiscal & external metrics c1ompare
poorly (see Table1).
*Note prepared by Amír Khan (Email:Amir.khan.uk0709@gmail.com) | August2018
B

2. 2. Available options to provide support
The first thing to highlight here is that Bahrain’s fiscal challenges are not anything new.
Indeed, even before the oil price collapse of 2014, Bahrain was running up large
annual budget deficits, swelling the national debt to around $31bn – or 89 percent of
gross domestic product – the International Monetary Fund said in a March report.
However, faced with the current crisis of confidence – which has in part been triggered
by the ending of the easy money policy on the part of the US Fed – the country has
been faced with escalating borrowing costs in the debt markets, with the result that
they have become prohibitively expensive for the country at least on a sustainable
basis. This is particularly true at the short-end of the yield curve (see chart).
Consequently, the country has effectively been shut out of the capital markets.
Against this bleak backdrop, Bahrain essentially has two options at its disposal:

3.  It could turn to the IMF for help. This normally takes the form of “Standby
Agreement” that entails concessional lending (i.e. at lower than market rates) but
which normally has strict conditions attached to it, including sharp cutbacks to
public expenditure.
 Second, it could – as it has already done – call on its wealthy neighbouring
countries, namely Saudi Arabia, UAE and Kuwait for vital funds, such as that which
were made available to the country in the aftermath of the 2011 Arab Spring
movement. Such funds take the form of grants or overseas aid and – unlike
borrowing from the market or indeed IMF – have traditionally carried little or no
explicit upfront costs. That said, my sense is that should the aforementioned
countries be forthcoming in providing financial support to Bahrain on this occasion
they will be more inclined to set formal conditions as to how the funds that they
provide should spent and indeed what, if any, corrective action should be taken on
the part of Bahrain.
3. The suggested amount needed
The amount that Bahrain needs is rather difficult to ascertain given the opaque nature
of its public finances. That said, if the IMF is to be believed, the kingdom posted a
deficit of close to $5bn last year and is projecting a shortfall of $3.5bn in 2018, inclusive
of the country’s external and domestic debt interest payments. Over and above this,
it’s also worth mentioning that, at $2.6bn, the country’s gross forex reserves, as at the
end of 2017, are inadequate and are only able to finance around 1.2 months of
imports, a figure which is well short of the IMF’s recommendation of 3 months. Taking
all this together, it’s reasonable to conclude that Bahrain would require a financial
assistance programme to the tune of $3.5-4bn for this year alone and – depending on
how long it’s shut out of the debt markets – something similar for the following two
years.
4. Policy responses to allow a return to capital markets
Going forward, there is a sense that Bahrain will have little or no choice but to instigate
cutbacks to its fiscal expenditure with a view to convincing the markets that it’s willing
to “cut its cloth according to it means”. To this end, the most obvious place to start
perhaps is to reduce its generous system of state subsidies which – along with other
state transfers – account for around third of its total expenses according to World Bank
data. Additionally, Bahrain will also need to introduce more structural measures on the
fiscal and growth front that may help to accelerate its return to the capital markets. In
this regard, the following measures may be worthy of note:
i) Introduction of a sales or value added tax, akin to that introduced by the UAE
and Saudi Arabia at the start of this year. Additionally, it could also consider the
introduction of corporate taxes, though these would have to be coordinated with
other GCC countries.
ii) Establish a dedicated debt management office to better coordinate the
government’s overall fiscal plans and that of individual governmental
departments. Additionally, this would also help to provide a better – and
perhaps more effective – interface with the markets when issuing debt.

4. iii) Foster an improvement in the business environment so that firms are more
willing to establish their operations in the country. Such efforts may particularly
target technology based firms, such as those in the fintech space, which could
perhaps seek to leverage the country’s already developed banking sector. Over
and above this, the country could also target biotech and renewable energy
companies, though these are already being eagerly courted by its regional
neighbours, namely the UAE.
iv) Expedite measures to improve the skill base of the country’s workforce by
offering better and more targeted training and retraining measures.
5. Political considerations & concluding remarks
A final point worth noting here is even if a comprehensive financial package was
immediate available to Bahrain, its challenges would not end there. For one thing,
Bahrain has historically been exposed to domestic political unrest due to friction
between the 30% minority – but ruling – Sunni population in a country where 70% of
the population are Shiite. Indeed, it is this disconnect that helps to explain why Bahrain
was the hardest-hit country among the GCC members during the Arab Spring unrest
of 2011. That said, on the plus side, Bahrain has very close relationships with other
GCC countries and, in particular, with Saudi Arabia – the most powerful of the GCC
members – who provides economic and political support when needed. Indeed, Saudi
Arabia has stated firmly that it will not permit, under any circumstances, a Shiite
takeover of Bahrain, and strongly backs the Bahrain ruling family, therefore providing
a stabilising force in the event of any political disturbance. On the economic front, it’s
widely recognised that Saudi Arabia, perhaps due to its own self-interest – not least,
the desire to preserve GCC currency pegs to the US dollar – will, in concert with other
GCC members, provide Bahrain with a financial backstop in the event that it runs into
any financial trouble. In fact, as noted earlier, this is something that we’ve already seen
during the course of the 2011 Arab Spring events – when GCC countries pledged
sizeable funds (>$7.5bn over 10 years) to Bahrain – and are likely do so again if the
preliminary discussions held between Bahrain & its GCC peers in June are anything
to go by. That said, the one key difference that’s worth dwelling on this time round is
that, as I’ve alluded to above, Saudi and the other wealthy GCC countries will be more
inclined to specify formal conditions in return for the bailout funds they extend to
Bahrain, a recognition of the fact that in the post-2014 oil price crash they too are
finding the going increasing difficult and that, as a consequence, their “kitties” are not
as full as they once used to be.
***