Bahrain outlook positive on improving fiscal trajectory

Solid growth in non-oil receipts and budget consolidation measures are easing pressure on Bahrain’s fiscal position.

We expect the government will continue pursuing reforms to reduce fiscal deficits that will place debt to GDP on a more sustainable path.

We also assume the country’s external vulnerabilities will decline amid current account surpluses over 2022-2024.

We therefore revised our outlook on Bahrain to positive from stable and affirmed our ‘B+/B’ ratings. Rating Action

On Nov. 25, 2022, S&P Global Ratings revised its outlook on Bahrain to positive from stable. At the same time, we affirmed our ‘B+/B’ long- and short-term foreign and local currency sovereign credit ratings.

The transfer and convertibility assessment on Bahrain remains ‘BB-’.

Outlook

The positive outlook indicates that we expect the government will continue implementing fiscal reforms to reduce the budget deficit and benefit from additional support from other Gulf Cooperation Council (GCC) sovereigns, if needed.

Upside scenario

We could raise the ratings over the next 12 months if the government’s budgetary position improves beyond our expectations, contributing to a sustained reduction in net debt to GDP alongside strong and sustained current account surpluses that would support Bahrain’s external position. Further support for an upgrade could come from an acceleration in productivity-led per capita economic growth.

Downside scenario

We could revise the outlook to stable if the government’s net debt and debt-servicing burden increase beyond our current assumptions despite fiscal consolidation measures. We could also revise the outlook to stable if foreign currency reserves decline sharply, limiting the government’s ability to service its external debt and weighing on monetary policy effectiveness.

Rationale

The positive outlook on Bahrain reflects the government’s ongoing implementation of the updated Fiscal Balance Program (FBP) via expenditure cuts and revenue-enhancing initiatives, including the doubling of the value-added tax (VAT) rate to 10% from 5% on Jan. 1, 2022. Preliminary fiscal data point to a minor balancedbudget position underpinned by an 120% increase in nominal tax revenue year on year, surpassing projected annual inflation of about 4%. At the same time, Bahrain’s economy is benefiting from the surge in regional activity tied to elevated oil prices. In second-quarter 2022, real GDP expanded 6.9% year on year, the highest pace of quarterly growth since 2011. In our view, the government’s willingness and ability to pursue budgetary reforms under the FBP has strengthened fiscal policymaking in recent years.

In first-half 2022, Bahrain posted a record current account surplus of about 17% of GDP, supported by high oil and aluminum prices. We forecast an external surplus of about 7.1% of GDP over 2022-2024, in line with the upward revision to our oil and aluminum price assumptions, before reverting to historical deficits of 5.4% of GDP in 2025 as commodity prices moderate. We assume an average Brent oil price of $100 per barrel (/bbl) for 2022, $90/bbl for 2023, $80/bbl for 2024, and $55/bbl from 2025 (see “S&P Global Ratings Revises Its Oil And Gas Price Assumptions On Supply/Demand Fundamentals,” published Nov. 18, 2022, on RatingsDirect).

Institutional and economic profile: Bahrain’s economy and budget remain sensitive to oil price volatility

The Bahraini government remains committed to its multi-year economic recovery plan targeting more than $30 billion of strategic investments to boost non-oil growth.

We expect the GCC will continue to extend political, economic, and financial support to Bahrain, if needed.

We note improvements in policymaking since the adoption of the FBP in late 2018.

Bahrain’s relatively diverse economy benefits from proximity to the large Saudi Arabian market, strong regulatory oversight of the financial sector, a relatively well-educated work force, and low-cost environment. However, when GDP performance from 2014-2025 is adjusted for population levels, real growth is flat, suggesting that labor supply, rather than capital investment or innovation, is a key growth spur. We estimate GDP per capita at about $27,300 in 2022.

Bahrain is a small non-OPEC oil producer whose obligations under the OPEC+ agreement do not restrict its production. Approximately 75% of Bahrain’s total oil production of about 200,000 barrels per day comes from the Abu Safa oil field shared with Saudi Arabia, with the remainder sourced from the onshore Bahrain field. Bahrain does not currently export gas, but its recent discovery of two new gas fields, al-Joubah and al-Jawf, could add further upside to our growth projections. In addition to hydrocarbons, exports of energy-intensive metals, particularly raw aluminum and aluminum wire, remain an important source of foreign currency earnings.

In second-quarter 2022, Bahrain’s real GDP expanded 6.9% year on year, reflecting the sustained recovery of regional tourism, transportation, and hospitality amid higher oil prices. Partially offsetting this was a 2.2% real contraction in the hydrocarbon sector year on year, owing to continued maintenance at the onshore Bahrain field. Notwithstanding Bahrain’s dependence on oil for its fiscal and external revenue, the contribution of hydrocarbons to GDP is much smaller at about 17%. This reflects a structural mismatch, which the government’s FBP is attempting to correct by raising taxes from non-oil revenue.

We expect the Bahraini economy will expand 4.8% in 2022 before decelerating to about 2.5% over 2023-2025 on the back of gradually declining commodity prices, slowing global growth, and tightening global financing conditions. Like most GCC sovereigns, Bahrain pegs the dinar (BHD) to the U.S. dollar, implying that its interest rate policy closely tracks that of the U.S. Federal Reserve (Fed).

Over the medium term, the government’s economic recovery plan will drive non-oil activity to spur domestic employment and attract investments in strategic sectors such as tourism, housing, roads, airports, and electricity. Associated projects include the building of five offshore cities and the development of the Bahrain metro. In our view, the availability of financing for these projects will remain contingent upon the state of public finances in key regional hydrocarbon exporters such as Saudi Arabia, which are linked to oil prices. At present, projects funded by the $7.5 billion GCC Development Fund--introduced by GCC partners in 2011 to support local infrastructure-will continue to support investment over the forecast period. However, the effects will wane as almost the full fund has been committed to projects, of which about $7.4 billion (48 projects) are underway or have been completed.

A delicate political situation has historically constrained the government’s ability to narrow its sizable budget deficits, although we note material improvements in fiscal policymaking since the introduction of the FBP in 2018. In 2019, for example, the government enacted its strongest fiscal consolidation measures since oil prices collapsed in 2015, introducing VAT and a voluntary retirement scheme for government employees. Nevertheless, in our opinion, there are still potential risks from the entrenched polarization between the Shia and Sunni communities, although these have abated somewhat in recent years.

Relations between Bahrain and most GCC sovereigns remain strong, exemplified by the $10.2 billion GCC Support Package pledged by Saudi Arabia, the United Arab Emirates (UAE), and Kuwait in 2018. Additionally, Bahrain and Israel recently announced their intention to sign a joint free-trade agreement by year-end 2022, signaling a relative improvement in relations.

Flexibility and performance profile: Higher oil prices and tax measures will ease pressure on Bahrain’s fiscal and external positions through 2023

Beyond 2023, we expect the fiscal trajectory will remain contingent on oil prices and the government’s appetite for continued budget consolidation.

Bahrain’s gross external financing needs are among the highest of our rated sovereigns due to the large external short-term debt of the wholesale and retail banking sectors.

We expect the likelihood of further GCC support will help maintain confidence in the Bahraini dinar’s peg to the U.S. dollar.

The Bahraini government updated and extended its FBP in October 2021, changing the target date for a balanced budget to 2024 from 2022 (assuming oil prices of $60/bbl). Aside from the VAT hike in 2022, the government aims to further increase non-oil revenue by raising fees and budget contributions from government-related entities and adding charges to government services from 2023. No major initiatives have been implemented on the expenditure front in 2022, but the government did maintain expenditure at 2021 levels despite rising debt interest payments. We expect further cuts to public sector, manpower, and capital spending, alongside rationalization of social subsidies, over 2023-2024. This contrasts with the previous plan, where the onus of fiscal consolidation was on raising non-oil revenue, after expenditure-reducing measures in 2019.

Preliminary fiscal data for the first nine months of 2022 highlight a modest surplus of less than 1% of GDP, the first since 2014. This is underpinned by favorable hydrocarbon prices and strengthened non-oil tax revenue following the doubling of the VAT rate to 10% from 5%. We expect the government’s continued commitment to fiscal reforms, combined with robust hydrocarbon prices, will contribute to a full-year budget surplus of 0.2% of GDP in 2022 (suggesting Bahrain’s fiscal breakeven oil price is about $100/bbl). Beyond this, we forecast a widening deficit averaging 2.7% of GDP over 2023-2025 as oil receipts, the largest component of government revenue, decline in line with our oil price assumptions.

Government interest payments are rising but remain moderated by interest-free GCC loans. We expect them to total about 28% of government revenue in 2022, up from 13% in 2015. In our view, the cost of debt is high, with interest to revenue averaging about 29% over 20232025, partially due to Bahrain’s low and volatile general government revenue compared to other sovereigns rated in the ‘B’ category. However, the GCC support package, accounting for about 20% of total government debt, means the interest burden is not increasing as fast as it might otherwise. These funds have a zero-interest rate, seven-year grace period, and 30-year term. In addition, the government’s liabilities to the Central Bank of Bahrain (CBB), at about 14% of total debt, do not carry an interest charge.

High debt constrains the government’s fiscal flexibility, in our view. Gross debt fell to 123% of GDP in 2022 and we expect it will stabilize at this level over 20232025, including GCC support funds and borrowings from the CBB. Our debt forecasts include an additional 2% of GDP in annual government debt accumulation over the budget deficit, related to historical off-budget spending on defense and the Royal Court.

The majority of Bahrain’s debt is denominated in foreign currency. At Sept. 30, 2022, 57% of total debt was in U.S. dollars, up from 48% in 2016, not including liabilities to the CBB (BHD2.6 billion, or 14% of GDP). Dinar-denominated debt has not increased significantly since year-end 2018. We anticipate the government will continue to prefer external dollar issuance because this supports foreign exchange (FX) reserves, which are needed to refinance upcoming dollar-denominated maturities, and the GCC support funds are dollar-denominated. Despite Bahrain’s large banking sector, this creates a reliance on external investors for the government’s funding needs and the economy’s foreign currency needs.

Unlike other oil exporters in the Gulf, Bahrain does not have significant external liquid assets. We estimate government assets, predominately held domestically, will average 13% of GDP over 2022-2025. Most assets included in our estimate come from the Social Insurance Organization and the Future Generations Reserve Fund (FGRF). To replenish the FGRF following COVID-19-related withdrawals, the government will increase its contribution by setting aside $2 for every barrel of crude exported at a price greater than $80/bbl and $3 for prices exceeding $120/bbl from 2023. It will maintain its existing contribution of $1/bbl should oil prices average below $80/bbl.

We consider the government’s contingent liabilities from the public sector and the resident retail banking sector limited. In assessing the banking sector as a potential contingent liability, we consider only resident retail banks. In our view, if wholesale banks were in financial distress, the government would not bear the full cost because most are foreign owned. Bahrain’s large domestic retail banking sector has gross assets estimated at over 240% of GDP and our banking industry country risk assessment positions the banking sector in group ‘7’ (on a scale of ‘1’ to ‘10’, with ‘1’ denoting the lowest risk; see “Banking Industry Country Risk Assessment: Bahrain,” published May 19, 2022).

We expect Bahrain will receive full disbursements under the $10.2 billion GCC Support Package, and there remains potential for additional financial support beyond the program’s expiration at year-end 2023. We estimate Bahrain received $8.2 billion over 2018-2021, with an additional $1.4 billion and $650 million to be disbursed in 2022 and 2023, respectively. We assume these longterm, interest-free loans will cover about 50% of the government’s financing needs over 2022-2023, in line with recent years, although we note disbursements typically do not align with Bahrain’s debt repayments. That said, we assume the sovereign will continue to maintain good access to international capital market funding.

We expect the favorable external environment will enable Bahrain to achieve another current account surplus of 10.9% of GDP in 2022, up from 6.7% in 2021. Although income payments and workers’ remittances will remain a drain on the external balance, stronger receipts from tourism and financial services tied to the normalization of economic activity will help shore up the services account. We forecast the current account position will revert to historical deficits of about 5% of GDP by 2025, in line with our assumptions of declining commodity prices. The deficit will be financed primarily through government external debt issuance, a rebound in foreign direct investment, and a drawdown on FX reserves.

Bahrain’s gross external financing needs are among the highest of rated sovereigns and average an estimated 2.8x current account receipts plus usable reserves over 20222025. The high external financing needs reflect large financial sector external debt, estimated at about 145% of GDP. This includes potentially flight-prone nonresident deposits of over 30% of GDP, although we note their relative stability over the past few years. More than offsetting this are the financial sector’s external assets, estimated at 260% of GDP, or two-thirds of the economy’s total foreign assets. These assets are likely less liquid and have longer tenors than the banking system’s funding base.

Data gaps, including the omission of large nonbank private sector entities such as Nogaholding and Gulf Air from the international investment position (IIP), restrict our visibility on external risks. Additionally, unlike our assessment of contingent liabilities, in our external risk analysis the IIP includes both domestically registered retail and wholesale banks and foreign branches of retail banks. We estimate that locally registered wholesale banks are about 80% foreign owned, and that their exclusion from the IIP would place Bahrain’s economy in a net external liability rather than asset position. Separately, we understand that sovereign wealth fund Mumtalakat’s foreign assets and liabilities have been included in the IIP since first-quarter 2022, prompting a sharp increase in the stock of outward direct investment and inward portfolio investment.

Bahrain faces external redemptions of about $2 billion (5% of GDP) annually from a combination of Eurobond and sukuk issuances, including a $500 million Eurobond maturing in April 2023 and a $1.5 billion Eurobond maturing in August 2023. We understand the government is still exploring options to refinance these upcoming redemptions, which could include a draw-down on FX reserves, private placements, or additional external or domestic market issuances depending on conditions.

Inflationary pressures have increased but remain subdued by global standards. The headline consumer price index accelerated to 4% year on year in August 2022, driven by higher food and beverage, transport, and hotel and restaurant prices. Consequently, we raised our inflation forecast to 3.8% on average for 2022, compared with deflation of 0.6% in 2021. Upward pressure on inflation could weigh on private sector confidence and drag on medium-term economic growth.

Monetary policy flexibility is limited: Bahrain’s domestic currency, the dinar, is pegged to the U.S. dollar, and interest rate policy closely tracks that of the Fed. Also, we consider that the CBB has a limited ability to maintain this exchange-rate arrangement--notwithstanding our view that the peg will remain in place over the medium term--because the country’s FX reserves do not cover the monetary base. The CBB raised its main policy rate 75 basis points (bps) to 4.75% in October 2022, in lockstep with the Fed’s rate hike that month.

Bahrain’s FX reserve replenishment has historically come from government external issuance and fiscal support from other GCC sovereigns. Notwithstanding our assumption of current account surpluses over 2022-2024, we assume gross FX reserves will remain relatively stable at $5.0 billion at year-end 2022 and useable reserves at negative $6.7 billion (after deducting the monetary base and FX swaps with domestic banks), owing to the repayment of maturing foreign debt. We understand the Ministry of Finance must convert its U.S.-dollar-denominated oil export revenue into local currency equivalents at the CBB (for fiscal expenditure purposes) for the proceeds to be included under FX reserves.

Bahrain’s banking system remains relatively resilient with regulations broadly in line with those of regional peers. Domestic private sector loan growth accelerated to 5.3% year on year in September 2022, compared with 4.1% at year-end 2021, spurred by the recovering retail sector. We forecast credit extension will remain robust at 6% over 2022-2025, owing to strong economic activity. However, systemwide nonperforming loans are projected to increase to 5.5%-6.0% of total loans over 2022-2023, from 3.3% in September 2022, following the termination of the CBB’s deferral scheme at end-June 2022.