Subsidy cuts a tricky task for Bahrain's government

In a low-tax nation such as Bahrain the obvious part of the balance sheet to look at when addressing a stubborn fiscal deficit is government spending. It is hardly surprising, then, that over the past year the question of government subsidies has come to the fore in the public debate on the nation’s challenging economic situation.

While the Gulf Assistance Programme has allowed Bahrain to maintain its capital spending levels, current spending is still underwritten by government revenue, and with oil prices remaining depressed the Ministry of Finance is keen to cut both its spending and its deficit.

Subsidies are an obvious target in any such exercise, which in Bahrain’s case means government support for essential staples such as meat, flour, gas, petrol, diesel, electricity and water. Reducing or removing them, however, is no simple matter, and almost every option open to the ministry’s economic planners carries risk.

Regional Issue

Bahrain is not alone in facing a subsidy challenge. According to the IMF, rising break-even oil prices and shrinking fiscal surpluses mean that the average fiscal balance of MENA oil exporters is expected to turn into a deficit starting in 2017. Recent economic and political events have placed pressure on the coffers of regional governments: the global financial crisis and domestic social pressures exacerbated by the Arab Spring have compelled finance ministries from Morocco to Oman to boost public wages and social spending in an effort to ensure stability. Compounding this is a structural problem in fiscal policy that the IMF has called a “ratchet effect”, by which spending increases introduced when oil prices are high are not reversed when prices fall to lower levels.

Pushing more money into public spending such as wages, infrastructure and subsidies, the argument goes, is more politically rewarding in the short term than shoring up sovereign wealth funds or central bank reserves. The result of this tendency, though, is for governments to become more dependent on high oil prices to finance their elevated expenditures. When oil prices fall, reversing the ratchet effect is politically costly, and in nations with vocal parliamentary bodies, like Bahrain, cutting back on the government largesse that has accumulated on the nation’s balance sheet over decades presents a sizeable challenge.

Consolidation

The need for fiscal consolidation is well understood. The IMF predicts that Bahrain’s structural fiscal deficit will only widen in the future, with public debt expected to reach 63% of GDP in 2018, up from 37% in 2012.

Reining in public sector wages, boosting non-oil revenues, rationalising capital expenditures and reforming the pension fund may all bring the possibility of modest consolidation over the long term, but for many the struggle to cut back on generous government subsidies is the most important battle in the wider attack on the deficit.

Fuel

Bahrain has already had a measure of success in reforming its fuel subsidy bill. Industrial tariffs for gas were increased by 50% on January 1, 2012, resulting in an annual estimated saving of 1.4% of GDP, according to the IMF. Similar moves have also been made elsewhere – in Egypt, for example – but for Bahrain the tariff change had particular significance, as the nation’s manufacturing base is dominated by the aluminium industry, which has grown up around Aluminium Bahrain (Alba). The publicly listed firms operates one of the largest smelters in the world, producing sheet ingots, foundry alloy ingots, extrusion billets and liquid metal both for export and for a host of downstream industries in the country. The aluminium segment is therefore systemically important to the kingdom’s economic diversification efforts.

However, fears that the tariff hike would challenge the profitability and competitiveness of this important economic segment proved unfounded, thanks in large part to the still relatively low price of gas. The government’s current focus is on further amendments to natural gas pricing for businesses and expatriates, to take place over a transition period that will end with the introduction of rates that reflect the real cost of gas production or import. Similarly, subsidies on diesel and kerosene will be gradually withdrawn, with exceptions made for fishermen and traditional bakeries.

Food

Food subsidies are also due to decrease in the short term. As with fuel subsidies, Bahrain has a successful track record of cutting spending on foodstuffs, having lifted government support for sugar and rice two decades ago.

The government now plans to make savings by cutting back on meat subsidies, stating its intention to do so in May 2015. In this case, the risk that comes with the decision is political more than economic. Subsidy adjustments that result in increased food prices are never popular, and unfortunate precedents in the region act as reminders as to the sensitivity of the issue.

In Bahrain, removal of the meat subsidy will see the price of lamb rise from BD1 ($2.63) per kilo to something more like the rates seen in countries with free price completion. In Kuwait, the cost of Australian lamb ranges from BD2.1 ($5.53) to BD2.8 ($7.38) per kilo, while prices in the UAE can rise to as much as BD3.4 ($8.96), suggesting that a liberalised price in Bahrain will be more than double the current subsidised rate.

The government is, therefore, taking a cautious approach as it sets about removing its meat subsidy system. Having announced in August 2015 that subsidies would be removed in September, the prime minister, Sheikh Khalifa bin Salman Al Khalifa, stepped in as the deadline passed to announce that the plan would not be enacted until October 1, in order for a joint committee of Cabinet and members of parliament to study data and “discuss all the plausible alternatives and options”. The removal of meat subsidies went ahead as planned from the start of October 2015.

The government has also sought to protect citizens from the expected price rises through a cash compensation scheme, which will exclude the non-Bahrainis who make up approximately half of the nation’s population. According to the mitigation programme, eligible households will be compensated for rising meat prices at a rate of BD5 ($13.17) monthly for each breadwinner, plus BD3.5 ($9.22) for every additional adult and a further BD2.5 ($6.59) for each child.

Utilities

After food subsidies, fiscal support for electricity and water is next in line in the government’s expenditure reduction programme. The potential gains for the state in this effort are significant: according to the general budget for the fiscal years 2015 and 2016, subsidies directed to the Electricity and Water Authority will amount to BD325.5m ($857.5m) and BD315.7m ($831.7m), respectively. This represents the single largest expenditure on the government’s subsidy list.

Plans regarding this section of its subsidy bill remain at an early stage, and in mid-2015 the joint government-parliamentary committee formed to discuss subsidy cuts agreed that spending on electricity and water subsidies for citizens’ homes would remain in place for 2015 and 2016. When the government is ready to move, it already has a stepped tariff system in place by which it can target its subsidy cuts more finely.

Currently, electricity for residences is priced at three rates, according to usage, while there are separate rates for commercial and industrial use. Water rates run in two bands, according to usage.

Challenges

The political risk inherent in any subsidy reduction programme explains the government’s keenness to protect citizens from price increases. Thus, in most public statements on the subject, the authorities have stressed that nationals will either be excluded from cuts or will be compensated by cash transfer programmes. However, subsidy reform limited to expatriates is likely to encourage some foreign residents to leave Bahrain unless they can secure higher salaries in order to meet the rise in the cost of living.

Critics of the proposed changes have therefore suggested that subsidy cuts should be targeted at the wealthiest in society, Bahraini or expatriate, rather than a section of the population that contains many low-paid workers. Achieving a balance between safeguarding the interests of citizens and meeting the needs of expatriates who in many cases have lived in Bahrain for decades is thus likely to be a priority in the subsidy negotiations between the Cabinet and the National Assembly.