Bahrain downgraded by S&P to BBB-/A-3 on sharp decline in oil prices

On 9 February 2015, Standard & Poor’s Ratings Services lowered its long- and short-term foreign and local currency sovereign credit ratings on the Kingdom of Bahrain to ‘BBB-/A-3’ from ‘BBB/A-2’. At the same time, it lowered the long- and short-term foreign and local currency credit ratings on the Central Bank of Bahrain to ‘BBB-/A-3’ from ‘BBB/A-2’. The outlooks on both Bahrain and its central bank remain negative.

Prices for crude oil in spot and futures markets have dropped more than 50 per cent since June 2014, leading Standard & Poor’s to revise down its oil price assumptions significantly over 2015-2018. When S&P reviewed Bahrain in December 2014, the agency expected Brent oil prices to average $80 per barrel (/bbl) in 2015 and $83/bbl in 2015-2018. S&P now assumes an average Brent oil price of $55/bbl in 2015 and $70/bbl in 2015-2018. Consequently, it has revised forecasts for Bahrain’s economic growth, fiscal position, and current account.

Over 2014, Bahrain derived approximately 65 per cent of its fiscal revenues from crude oil receipts, which are part of the 84 per cent of total revenues derived from the oil and gas industry. Bahrain’s fiscal break-even oil price, estimated at nearly $125/bbl of oil in 2014, was the highest of all Gulf Cooperation Council (GCC; Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates) members.

S&P said, “This compares with an average of $52/bbl between 2000 and 2010. We view this as an erosion of the longer-term sustainability of Bahrain’s fiscal position. Recurrent expenditures increased to 90 per cent of total expenditures in 2014 from 81 per cent in 2009, and wages and salaries account for 42 per cent of total expenditures, with subsidies representing another 30 per cent. These increasingly burdensome social expenditures underpin Bahrain’s pronounced vulnerability to oil prices. The government’s debt burden has doubled since 2009 and stood at some 43 per cent of GDP at the end of 2014. We estimate that the government will be in a net debt position of almost 20 per cent of GDP by the end of 2015, from 10 per cent of GDP in 2014 and a net asset position of 12 per cent of GDP in 2010.

“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 government in place since the parliamentary elections on 29 November 2014. We expect that the 2015-2016 budget currently under parliamentary review will contain a number of expenditure measures, in particular a severe reduction in capital spending to about two per cent of GDP, from a figure closer to six per cent of GDP over the past few years. However, we believe that political sensitivities will result in smaller reductions in recurrent expenditures. As a result, our fiscal projections now show Bahrain’s general government deficit widening to eight per cent of GDP in 2015, compared with our previous estimate of 4 per cent, and compared with a surplus that averaged 1 per cent of GDP over 2007-2013. The government’s ability to implement more deep-rooted expenditure cuts or introduce taxes in an effort to balance fiscal results on a recurring basis in a delicate political environment remains its main challenge, in our opinion.

“The fall in oil prices has also affected our analysis of Bahrain’s external accounts. We now expect the current account will fall into a slight deficit in 2015, 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 decline as a result, 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 as a result of a historical statistical discrepancy relating to the the size of the financial system, much of which has limited bearing on the domestic economy. While the exact external asset exposures of the wholesale banks (80 per cent of the total system) are uncertain, the majority is to head offices, other banks, and securities. We treat these assets as liquid, in line with an international financial sector. They also account for the very high stock of short-term external debt of 5x current account receipts.

“We continue to assume that regional financial support will be forthcoming when needed in both our fiscal and external assessment of Bahrain’s creditworthiness. However, beyond 2015, the terms and timing of such support remain less certain, in our opinion. Furthermore, we believe that increasing this dependency could reinforce policy complacency, with the potential to undermine Bahrain’s credit quality.

“We believe that disbursements from the GCC Development Fund, with approximately $10 billion in funding committed over a 10-year period, will offset government capital expenditure cuts and will act as a key growth contributor. We think that real GDP growth will slow a little more than previously, as regional demand decreases, but that growth will remain positive at about two per cent over 2015-2018. 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. 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 shown resilience 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 its low cost environment still provide incentives for investment and create potential for the future growth of the non-oil economy, representing approximately 75 per cent of total GDP. Moreover, 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 business (who by law hold majority stakes in all businesses) are also signs of a relatively business-friendly policy setting. However, we believe the already high level of competition in financial services–locally and regionally, particularly from Dubai–will limit 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. While these factors limit upside growth potential, we expect that slower rates of immigration, which are a key determinant of population growth, could feed through into higher GDP per capita growth figures.

“Despite Bahrain’s 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 on 30 September 2014). In our view, the real estate and construction sector remains in a correction phase, which has contributed to the building up of a large percentage of problem assets.

“We do not expect that the Central Bank of Bahrain would act as a lender of last resort for offshore banks. But 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.

OUTLOOK

“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 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 as forthcoming as we expect, causing our fiscal deficit assumptions to be markedly exceeded or growth to be substantially lower than we currently expect.

“We could revise the outlook to stable if the Bahraini government embarked on a credible path to fiscal sustainability or if oil prices outstripped our current assumptions, thereby reducing fiscal deficits and limiting increases in government indebtedness.”