S&P: Bahrain outlook revised to negative on weakening fiscal position; ‘BBB/A-2’ ratings affirmed

On Dec. 12, 2014, Standard & Poor’s Ratings Services revised its outlook on the Kingdom of Bahrain to negative from stable and affirmed its ‘BBB/A-2’ long- and short-term foreign and local currency sovereign credit ratings.

“At the same time, we revised our outlook on the Central Bank of Bahrain to negative from stable and affirmed our ‘BBB/A-2’ long- and short-term counterparty credit ratings on the bank.

“We think a period of lower oil prices will exacerbate existing structural weaknesses in Bahrain’s public finances. If the resulting squeeze on government revenues does not translate into reform that improves the sustainability of Bahrain’s fiscal position, this could put pressure on the ratings. However, our growth expectations for Bahrain remain stable, linked to forthcoming disbursements from the Gulf Cooperation Council (GCC) Development Fund and to Bahrain’s relatively diversified economic base that government policy has encouraged. These factors support the ratings.

“Importantly, the longer-term sustainability of Bahrain’s fiscal position has, in our opinion, continued to erode, with recurrent expenditures increasing to 90 per cent of total expenditures this year, from 81 per cent in 2009. Wages and salaries now account for 42 per cent of total expenditures, with subsidies representing another 30 per cent. As a result, Bahrain’s fiscal breakeven has increased to approximately $120 per barrel, from an average of $52 per barrel between 2000 and 2010, further illustrating both its pronounced vulnerability to oil prices and increasingly burdensome social expenditures. The government’s debt burden has doubled since 2009 and stands at some 42 per cent of GDP. We estimate that the government is now in a net debt position of almost 10 per cent of GDP.

“We view the implementation of tangible and sustainable reform that reduces Bahrain’s fiscal dependency on volatile oil prices as a key challenge for the new government in place since the Nov. 29, 2014, parliamentary elections. Our fiscal projections show Bahrain’s deficit widening to four per cent of GDP in 2015, compared with our estimated 2.7 per cent in 2014, and after a surplus that averaged one per cent of GDP over 2007-2013. Central to these estimates is our assumption that the government will vastly reduce its capital expenditures, by about 70 per cent of the $2.2 billion budgeted in 2014. We believe this is feasible in the short term because the GCC Development Fund, with approximately $10 billion in funding committed over a 10-year period, has started to disburse funds that will likely offset these cuts. The fund has disbursed an estimated $150 million (0.4 per cent of GDP) to date this year, and we expect it will disburse a further $750 million (2.1 per cent of GDP) in 2015. Still, although we think the new government will adopt these measures, or similar ones, in the 2015 budget, its ability to implement more deep-rooted expenditure cuts under current lower oil prices or introduce taxes in an effort to balance fiscal results on a recurring basis in the delicate political environment remains untested.

“We also think that the successful disbursement of GCC funds will replace government expenditures as a key growth contributor, and real GDP growth will slow only moderately to average just above 3 per cent over 2014-2017 as a result. These funds are intended to promote private sector activity (albeit with little local bank financing) and improve Bahrain’s infrastructure. Projects underway include housing, new roads, and schools.

“Bahrain’s economic performance has proven resilient to shocks and real GDP growth averaged more than 4.5 per cent between 2007 and 2013. Bahrain’s proximity to Saudi Arabia, its strong regulatory oversight, a relatively well-educated workforce, and low cost environment still provide incentives for investment and provide potential for the future growth of the non-oil economy, representing approximately 75 per cent of total GDP. Furthermore, measures to ease restrictions on foreign participation in the labor force have improved flexibility for employers. Regulations that afford flexibility to foreign investors when managing their relationships with local businesses (who by law hold majority stakes in all businesses) are also signs of a relatively business-friendly policy setting. However, the already high level of competition in financial services, locally and regionally (particularly from Dubai) limits the scope for growth at Bahrain’s offshore and retail banks. As a result of this and the reduced confidence triggered by lower oil prices, we think the need to bring foreign talent into the workforce will slacken. We expect that slower rates of immigration, which are a key determinant of population growth, will feed through into higher GDP per capita growth figures.

“Despite Bahrain’s relatively large financial sector and high number of majority-government-owned companies, we consider its contingent liabilities to be limited. On average, banks display high regulatory capital positions. We expect that competition will continue to strain profitability at Bahraini retail banks, encouraging further consolidation. Although the size of the overall banking system has declined by about 25 per cent since its peak in 2008, driven by offshore banks’ balance sheet downsizing, in our base-case scenario we assume that outflows, in terms of both external funding and the physical presence of international banks, will be contained. Bahrain’s retail banks carry a large credit exposure to the real estate and construction sector (about one-fifth of total lending as of Sept. 30, 2014). In our view, this economic sector remains in a correction phase, which contributed to the building up of a relatively large percentage of problem assets.

“We do not expect that the Central Bank of Bahrain would act as lender of last resort for offshore banks. We view the Bahraini government as a potential source of support for wholesale institutions not covered by parent entities or home countries but still important from a systemic or reputational standpoint. Consequently, we include all wholesale banks’ external liabilities in our assessment of Bahrain’s external financing needs.

“We expect the current account to remain in surplus, although we forecast that it will decline significantly and in line with our lower oil price assumptions, given that approximately 80 per cent of exports are linked to oil. Bahrain’s services balance is related to the profitability of the financial sector and could therefore deteriorate slightly under the impact from weaker oil prices. We expect that corresponding outflows from the financial account will consequently decline, albeit with a potential time-lag, as prices feed through the financial system. We continue to believe that Bahrain’s external stock position could be significantly overstated because it is clouded by statistical discrepancies and the size of the financial system, much of which has limited bearing on the domestic economy.

“We understand that the recent elections were held without any major violations. Although we anticipate that Bahrain’s political tensions will continue, we also believe that the overall security environment is calmer. Although we consider that the government has established a post-crisis status quo, Bahrain still faces occasional street protests, entrenched polarization between the Shia and Sunni communities, internal communal divisions, and an uncertain economic policymaking agenda.

“The negative outlook reflects our view of Bahrain’s weakening fiscal profile and its uncertain policy response. We could lower the ratings over the next year if our current fiscal deficit assumptions are materially exceeded, or if measures to combat falling government revenues do not aim for a structural improvement in Bahrain’s public finances that would in turn reduce its reliance on oil revenue and contain expenditures. We could also lower the ratings if GCC development funds are not forthcoming as expected, causing our fiscal deficit assumptions to be materially exceeded or growth to be substantially lower than we currently expect.

“We could revise the outlook to stable if the government embarks on a credible path to fiscal sustainability.”