New strategy and support package to help bridge Bahrain's deficit

Bahrain is among the smaller economies in the GCC, but it is also one of the more diversified ones, with particularly well-developed financial services and manufacturing sectors. Despite its diversified economy, Bahrain nonetheless faced pressures in recent years as a result of the 2014-15 drop in oil prices.

However, an aid package from other Gulf states announced in late 2018 and an accompanying fiscal-adjustment plan, as well as growth on the back of a partial oil price recovery and a recent major oil and gas discovery, offer hope for a turnaround in 2019.

Development Strategy

In 2008 the authorities launched a strategy for the kingdom’s long-term economic development, Bahrain Economic Vision 2030. The plan aims to further diversify the economy away from oil and is based on three core elements, namely enhancing productivity and skills; developing high-potential and export-oriented industries; and capturing emerging opportunities by facilitating entrepreneurship and improving access to venture capital as well as capital in general.

Bahrain’s wider economic strategy is based heavily on infrastructure development, much of it funded externally. In 2011, amid the Arab Spring protests, Kuwait, Saudi Arabia, Qatar and the UAE pledged $10bn in financial support to the kingdom in order to upgrade its infrastructure. The amount has since fallen to $7.5bn as Bahrain, together with Saudi Arabia and the UAE, cut off ties with Qatar over a political dispute. The aid comes from the Gulf Development Fund, which is financing an ambitious infrastructure investment programme that includes the construction of a new international airport terminal to replace the existing facility (see Transport chapter). Much of the money has yet to be spent, as all outlays must be allocated to individual projects, which take time to develop and put out to tender. However, nearly $700m of funds were spent in 2017, according to credit ratings agency Moody’s, pointing to a recent uptick in disbursements. When spending under the fund is combined with government and private sector investment plans, the kingdom reportedly has around $32bn of critical infrastructure development in the pipeline.

Monetary Policy & Foreign Exchange

The Bahraini dinar is pegged to the US dollar at a rate of $1:BD0.376. This is the case for all GCC currencies – with the exception of the Kuwaiti dinar, which is pegged to a dollar-denominated currency basket – and results from the major role that oil, which is priced in dollars, plays in the regional economy. The peg prevents the Central Bank of Bahrain (CBB) from operating an independent monetary policy.

The 2014-15 oil price slump and the resulting current account deficit, together with rising government debt, put the currency under pressure, leading the CBB in June 2018 to issue a statement detailing its continued commitment to keeping the peg in place. The announcement of another $10bn support package from the GCC in October 2018 has helped further to reduce pressure and curb speculation that the currency peg would be removed.

Output & Growth

According to figures from the Bahrain Economic Development Board (EDB), GDP growth for 2017 stood at 3.9%, up from a rate of 3.2% the previous year and also on 2015’s expansion of 2.9%. National economic growth was largely driven by the non-oil sector, which expanded at a rate of 5%, compared to a contraction in oil GDP of 0.8%, making Bahrain one of the most diversified economies in the region. Figures from the Information and eGovernment Authority, meanwhile, show that GDP reached BD13.3bn ($35.2bn) in 2017, the latest year for which full-year data is available.

In its October 2018 “World Economic Outlook”, the IMF forecast the kingdom’s GDP at constant prices would moderate to a growth rate of 3.2% in 2018, and further to 2.6% in 2019 and 2.5% in 2020. Allowing for the recovery witnessed in global oil prices in 2017 – which arguably gives a more accurate depiction of growth in an oil-dependent economy – the oil economy grew by 22.7% over the course of the year, compared to sharp falls the previous two years. This helped push nominal GDP growth up to 9.6%, compared to 3.5% in 2016, according to the EDB.

GDP in current prices grew by 5.1% year-on-year (y-o-y) in the first quarter of 2018 and by 8.3% y-o-y in the following quarter, bolstered by increases in the value of oil and gas production of 17.3% and 40.2%, respectively. In constant prices, overall growth for the first quarter of 2018 dropped from 4.6% to -1.2%, due largely to a 14.7% decrease in hydrocarbons output, before rebounding moderately in the following quarter, from 4.7% to 2.4%.

The IMF estimated GDP per capita at BD9146 ($24,200) in 2017, up from BD8511 ($22,600) the previous year. In purchasing power parity terms, GDP per capita stood at $47,500, according to the World Bank. This was the 23rd highest in the world and places the country firmly in the ranks of developed countries, between Belgium and Canada.

Key Contributors to GDP

According to the EDB, oil and gas is the largest sector of the economy, accounting for 18.4% of Bahrain’s real GDP in 2017. This compared to 19.2% the year before and 24% a decade earlier, in 2007.

The contribution of the hydrocarbons industry to the economy appears set to rise substantially in the medium to long term following the discovery of a new oil and gas field in 2018 (see Energy chapter). Bahrain announced the discovery of a new gas field in April 2018, its greatest find since 1932. Located off the country’s west coast, the Khaleej Al Bahrain basin covers an area of 6000 sq km and is estimated to hold 81bn barrels of oil and 14trn standard cu feet of gas. The discovery is expected to revitalise the energy sector and help boost local industry, although it will take an estimated five years or more to bring the new oil deposits on-line.

The second-largest economic sector is the financial services industry, with a GDP of BD2.2bn ($5.8bn) in 2017, or 16.7% of national output. This compared to 16.5% the year before and 17.6% in 2007. Manufacturing came in as the third-largest sector, accounting for 14.5% of GDP in 2017. A major subsector within manufacturing is aluminium production, which is carried out by majority-state-owned smelter Aluminium Bahrain (Alba). The company’s management has put the subsector’s contribution to GDP at around 12%. Alba’s contribution to the economy is expected to rise when a new potline, Line 6, comes on-stream, increasing production capacity at the company by around 50% (see Industry chapter).

Jarmo Kotilaine, chief economic advisor at the EDB, said that the growing importance of manufacturing is part of a wider a shift in the composition of private sector economic activity in recent years. “In particular, the importance of residential real estate has fallen somewhat, as that of manufacturing has increased,” he told OBG. “Bahraini manufacturing benefits from both cost and location advantages, and the access to a locally sourced workforce is also a significant asset,” Kotilaine added.

Exports & Imports

Overall exports of goods were worth BD5.8bn ($15.4bn) in 2017, the latest period for which full-year data is available from the Information and e-Government Authority. This was up from BD4.8bn ($12.7bn) in 2016, but down from BD6.2bn ($16.4bn) in 2015 and BD9.6bn ($25.4bn) in 2013. The fluctuations followed movements in the price of oil, which accounted for 54.7% of total exports in 2017. Non-oil exports for 2016 and 2017 were also down sharply compared to the three previous years. By contrast, exports of services have risen steadily every year since at least 2013, standing at BD4.3bn ($11.4bn) in 2017, up from BD4.1bn ($10.9bn) a year earlier, bringing the value of total exports of goods and services to BD10.1bn ($26.8bn). This was up on the previous two years, but down on 2013 and 2014 figures of BD12.8bn ($34.5bn) and BD12.1bn ($32.1bn), respectively.

According to World Trade Organisation (WTO) figures, manufactured goods accounted for the bulk of non-oil exports in 2017, excluding fuel and mining products, at a value of $4.2bn, ahead of agricultural exports at $441m. Within manufactured goods, machinery and transport equipment were the largest category of exports, at $1.42bn – although the dataset does not cover all types of goods. According to 2016 figures from the Observatory of Economic Complexity (OEC), which categorises exports differently than the WTO, Bahrain’s largest export by product grouping after mineral products was metals, at 23% of total outbound trading activity, followed by machines at 5.9%, and chemical products and textiles in joint third place at 4.9% each. The value of imports stood at BD6bn ($15.9bn) in 2017. Recent trends for imports are similar to those for exports due to the fact that the kingdom imports a significant amount of oil; crude oil purchases from abroad, mostly from Saudi Arabia, registered BD1.6bn ($4.2bn) in 2017. Imports of services for the year stood at BD2.9bn ($7.7bn), bringing the combined value of goods and services imports to BD9bn ($23.8bn), up from BD7.9bn ($20.9bn) a year earlier.

Trade Partners

As regards Bahrain’s trade partners, the largest destination for non-oil exports (not including re-exports) in 2017 was Saudi Arabia, accounting for BD482.9m ($1.3bn), or 23.1% of the total. In second was the US with BD340.2m ($901.4m), followed by the UAE with BD239.5m ($634.6m). Figures for total exports including oil are not available for 2017; however, in 2016 the kingdom’s largest export partner was Saudi Arabia with 19% of total exports, followed by the UAE (10%) and Japan (8.2%), according to figures from the OEC.

The fall in oil prices in 2014 and the subsequent drop in the value of exports has seen the kingdom develop a current account deficit since 2015. The shortfall was equivalent to 4.5% of GDP in 2017, down from 4.6% the previous year, according to IMF figures. In its October 2018 “World Economic Outlook”, the fund forecast that the fiscal deficit would contract further in 2018, to 2.5% of GDP.

Public Finances

Government revenue is dominated by oil and gas income; hydrocarbons revenue reached BD1.7bn ($4.5bn) in 2017, or 75% of total revenue, according to data from the Ministry of Finance. Combined revenue for that year stood at BD2.2bn ($5.9bn), up from BD1.9bn ($5bn) in 2016, and included BD1.4bn ($3.7bn) of oil revenue.

Meanwhile, total expenditure stood at BD2.5bn ($6.6bn), of which BD3.2bn ($8.5bn) consisted of recurrent expenditure and BD354.5m ($939.3m) of project spending. This yielded a deficit of BD1.3bn ($3.4bn), down from BD1.6bn ($4.2bn) in 2016 and below the projected deficit of BD1.4bn ($3.7bn) for 2018. The shortfall in public spending was equivalent to 10.1% of GDP, based on figures from the Information and eGovernment Authority.

The 2018 government budget was based on anticipated revenue of BD2.4bn ($6.4bn) and expected expenditure of BD3.7bn ($9.8bn), giving a budget deficit of BD1.32bn ($3.4bn), more or less unchanged from the deficit in 2017. Repayment of interest on public debt accounts for the largest share (15%) of planned outlays (not including expenditure under the Gulf Development Fund), followed by the defence sector (14%), public order and safety (12%), social protection (12%), and the economic and infrastructure sector (12%). Education accounts for 11% of the budget, general public services 10%, health 9%, housing 3%, and youth, culture and media 2%. High deficits incurred since the 2014-15 oil price slump have pushed up government debt in recent years, from 44.4% of GDP in 2014 to an estimated 88.5% in 2017, according to the IMF. This continuing rise in the deficit and debt led to a spike in the cost of insuring government securities, with credit default swaps climbing from 283 basis points at the end of April 2018 to a 19-month high of 380 basis points on May 22, 2018, as well as a fall in the value of the dinar to a 17-year low of 0.38261 to the US dollar in late June 2018. The government reportedly cancelled a planned international debt issue in March 2018 as a result of high interest rate demands from investors. Market confidence improved in late June 2018 when fellow Gulf states Saudi Arabia, Kuwait and the UAE announced they were holding discussions on providing financial support to the kingdom. However, this announcement did not prevent Moody’s from downgrading the kingdom’s long-term issuer rating from “B2” to “B1” in August 2018, maintaining a negative outlook for the country. The three states made good on their announcement in early October 2018 with an offer to provide the kingdom $10bn of financial aid over the period to 2022. The deal included the provision of $2bn before the end of the year and another $2bn during the course of 2019. With the aid secured, the Bahraini government announced that it did not intend to return to international financial markets in 2018, and the IMF forecast levels of government debt would remain more or less unchanged as a share of GDP on 2017 figures.

Fiscal Reform

The agreement to provide financial support appears to have been tied to a commitment by the government to reform the kingdom’s public finances, and shortly after the aid package was made public, the authorities announced a fiscal programme for the kingdom. Released in October 2018, the Fiscal Balance Programme 2018-22 includes an increase of between 2% and 2.5% of GDP in non-oil fiscal revenue, much of which will likely be accounted for by the introduction of a 5% value-added tax (VAT). The projected growth is also likely to achieved by measures such as increases in government fees and the possible introduction of an excise tax on soft drinks.

“The fact that a fiscal plan is in place is important and will help resolve market concerns that the aid package would just be a temporary fix,” Alexander Perjéssy, vice-president and sovereign risk group senior analyst at Moody’s, told OBG. Perjéssy said that the full implications of the programme were not clear because of unknowns, such as the oil price assumptions behind it, though the government has indicated prices of $60 per barrel. The plan aims to cut spending by 7% of GDP, which will mostly come from a voluntary retirement scheme for eligible civil servants, more targeted social transfers, increases in water and electricity tariffs, and savings from better spending efficiency and rationalisation.

In keeping with plans to cut spending under the fiscal balance plan, in late November 2018 international press reported that the Parliament was expected to quickly introduce a range of austerity measures in the wake of the legislative elections held earlier in the month. In previous rounds of cost-cutting, the authorities have attempted to minimise the impact on private Bahraini citizens – for example, by restricting utility price rises to business and foreign nationals. Despite the large implied cut to investment spending, major planned infrastructure spending appears likely to continue in coming years given that the bulk of the Gulf Development Fund has yet to be disbursed.

Taxes

A new consumption tax is also likely to play a major role in bolstering revenue. In October 2018 the Parliament approved the implementation of a 5% VAT on consumer goods, effective January 1, 2019. The move is part of a wider GCC agreement to introduce the consumption tax in all six member states, with the UAE and Saudi Arabia having already done so at the beginning of 2018. The move should provide fiscal support to the government, the value of which Perjéssy estimated at between 1% and 1.5% of GDP, though he said this would depend on how the tax is implemented. “In Saudi Arabia and the UAE, numerous exemptions have been put in place, including a lot of zero-rated items, which, if replicated in Bahrain, could reduce the impact on the budget,” he told OBG. Meanwhile, the EDB’s Kotilaine described the move as a game changer. “VAT will create a stable revenue flow for the non-oil economy, which accounts for the bulk of Bahrain’s GDP, and will be a big help in addressing fiscal sustainability issues,” he told OBG. The introduction of VAT at the same time as the government appears to be preparing further austerity measures has generated concerns about a potential fall in demand in the economy. However, Yousif Ali Mirza, CEO of credit card provider Credimax, said that he did not see this as a big concern. “The introduction of VAT in the UAE does not seem to have impacted consumer spending too much, and the proposed rate of 5% is low by international standards, so I do not see it having a major impact,” he told OBG. Kotilaine said that while the levy could temporarily hit business confidence and push up inflation by a handful of percentage points, the experience of both Saudi Arabia and the UAE showed that these effects would be short lived. He also pointed to several beneficial aspects of the tax in addition to raising fiscal revenues. “VAT will force companies to seek cost savings and efficiencies, which will help build stronger companies and achieve sustainable growth going forward,” Kotilaine told OBG. “Furthermore, it will also help to boost transparency and increase the amount of company and corporate sector data, which should in turn pave the way for more merger and acquisition activity, a more efficient capital market and more bank lending,” he added.

Moves to introduce VAT across the entire GCC, as well as pressures on regional public finances, have led to speculation that regional governments might seek to introduce other taxes as well, in particular corporate taxes. However, Kotilaine said that while this would be a decision for the government, it did not appear to fit in with the kingdom’s economic strategy. “If you cannot compete in market size, you have to compete in something else, and historically Bahrain has seen the absence of direct taxation as an advantage,” he told OBG.

Foreign Direct Investment

The value of inward foreign direct investment (FDI) flows to Bahrain stood at $518.9m in 2017, according to figures from the UN Conference on Trade and Development (UNCTAD), bringing total FDI stock supported by the EDB to $26.6bn. That was more than twice the value of inflows in 2016, which stood at $243.4m, and eight times larger than 2015 inflows of $64.9m. However, it remained down on the 2014 figure of $1.52bn, which in turn was worth less than half of 2013 inflows of $3.7bn – the largest in Bahrain’s history. Meanwhile, the EDB valued total investment in 2017 at $733m, spread across 71 companies and creating 2831 jobs. By region, the bulk of this ($497m) stemmed from North America, likely reflecting the investment by Amazon Web Services (AWS) to establish data centres in the kingdom (see ICT chapter). The second-largest investor was MENA, which accounted for $182m of the total.

By sector, the largest recipient of FDI was ICT, with $397m of the total, again likely driven by the AWS investment. The second-largest sector by inflows was manufacturing with $142m, followed by transport and logistics ($78m), financial services ($75m), and tourism and leisure ($31m).

Historically, FDI has been dominated by other countries in the region. The Information and eGovernment Authority reported that 57.2% of FDI stock was sourced from the GCC as of 2017. In line with this, the top-three contributors to FDI stock were all GCC countries, led by Kuwait, which accounted for the 21.3% of total stock. In second place was Saudi Arabia (16%) and in third was the UAE (10.9%).

Supporting Investment

Perhaps unsurprisingly then, the recent direction of the swings in FDI inflows as reported by the UNCTAD broadly tracks movements in oil prices. Oil prices have a significant impact on demand, both domestically and in the broader region, and therefore partially determine foreign investor appetite. The year-to-date recovery in oil prices in October 2018 appeared to bode well for investment flows to Bahrain, but in the months since the commodity’s value fell sharply, from $76 per barrel to $53 per barrel in early December 2018. However, other factors could offer support for investment. For example, Moody’s Perjéssy noted that the government appeared set on maintaining a favourable fiscal environment for investors. “Most GCC governments impose taxes on at least foreign non-oil companies, but there is resistance from the Bahraini government towards imposing any sort of profit and corporate income taxes, which should support FDI in the kingdom,” he told OBG.

In addition, Kotilaine cited several other supportive factors. “There is a more formal system now to attract FDI, based out of the EDB. The regulatory environment in place for foreign firms is also attractive and has now eased restrictions on 100% foreign ownership outside of free zones,” he said. “Furthermore, there has been substantial upwards pressure on costs in much of the region, whereas Bahrain remains quite competitive. Saudi Arabia is also attracting a lot of attention at the moment from investors, and setting up in Bahrain is an easy way of breaking into the market.”

Public-Private Partnerships

Another potential driver of foreign economic interest has been the rising prominence of public-private partnerships (PPPs) in the kingdom. The most distinguished PPPs in Bahrain are found in the electricity generation sector, where independent power projects (IPPs) and independent water and power projects (IWPPs) are flourishing. The contract for the first such project, the Al Ezzel IPP, was signed in 2004, and privately backed plants now account for the bulk of electricity produced in Bahrain. Another planned IPP, Al Dur 2, is due to come on-stream in 2020 (see Energy chapter). Additionally, the kingdom is promoting PPPs in the creation of social and affordable housing under the remit of the Ministry of Housing (see Construction & Real Estate chapter).

With public finances under pressure, using private funds to finance public infrastructure is becoming increasingly attractive for the authorities, and they are planning on expanding the financing model to other sectors. Most prominent among these is the transport sector, in which two major upcoming projects – the construction of a second causeway linking the kingdom to Saudi Arabia, which will feature both road lanes and a railway line; and a planned light rail network to be built in the capital, Manama – are due to be funded through such agreements. “The remit for PPPs is clearly expanding,” said Kotilaine. “The historic challenge was that implementation of such agreements was uneven across the region, with partnerships working well in the power and water sector, but non-existent in others, and there is a lack of off-the-shelf solutions that are easy to replicate across sectors and countries. However, interest is clearly growing, and there are interesting developments under way in Saudi Arabia that could create new models in fields such as aviation.”

Employment & Unemployment

According to figures from the Labour Market Regulatory Authority, there were 596,249 people employed in Bahrain at the end of June 2018, 84% of which were non-nationals. The largest sector by labour force size was construction, which employed 160,984 people, followed by sales, trading activities and motor vehicle repair in second place with 135,039 workers, and manufacturing in third on 69,131. Meanwhile, the unemployment rate stood at 3.6% in 2017, according to estimates from the IMF. The fund anticipated that the figure for the following year would increase slightly to 3.8%. The authorities have various initiatives in place to bolster employment of nationals and entrepreneurship. For instance, semi-autonomous government body Tamkeen seeks to support the private sector by supporting business growth and providing training to the kingdom’s workforce. The organisation offers support to both individuals, such as by providing jobseekers with professional certifications, and to pre-start-up firms, start-ups and established businesses. Services for the latter include subsidies for experienced employees worth 25% of their wages for three years, with subsidies for graduate employees rising to 70% of their wages in their first year, and subsidised loan programmes. Bahrain Development Bank, a state-owned bank primarily focused on financing locally owned small and medium-sized enterprises, is also playing a role in driving entrepreneurship and developing the private sector in the country (see Banking chapter).

As in other Gulf countries – many of which, like Bahrain, have large expatriate populations that dominate the workforce – the authorities are seeking to increase the number of nationals employed in local businesses through a process known as Bahrainisation. This was first introduced in 1996 and required Bahraini businesses to employ at least one national. The requirements for Bahrainisation vary from sector to sector and by the size of the company; and while some requirements have been dropped, and firms are free to hire as many expats as they want, they pay a higher fee for expats over their quotas.

Outlook

Several developments have bolstered the outlook for Bahrain’s economy. The agreement in October 2018 by three Gulf states to provide the kingdom with a financial support package will help to stabilise government finances and reduce market concerns about debt sustainability – though the sharp fall in oil prices in late 2018 underscores the importance of further progress in this regard. The fiscal programme accompanying the support package should help to put public finances on a more stable footing, though it remains to be seen to what extent the authorities will be able to implement politically sensitive austerity measures. While economic diversification remains a key priority for the government, the Khaleej Al Bahrain oilfield discovery in April 2018 is suggestive of long-term economic success on the back of increased oil and gas revenue.