Moody’s cautious on Islamic banking?

My favourite Gulf stat (only because it seems so perverse): Bahrain (665km²) is smaller than King Fahd airport (780km²). That is small for a country. And when you put it like that, and consider all Bahrain has achieved, like, you know, being the biggest centre of Islamic finance in the world, democracy, its very own airline (whether it still wants it or not) and all the rest, it seems more than a little mean of Moody's to have last week put the boot in. Given that the ratings agency missed the coming of the global financial crisis, Bahrain must be wondering just what it has done to get on the wrong side of it now.

Moody's says it doesn't think Bahrain has sufficient cash to be able to underwrite its banking sector anymore, and has consequently downgraded the investment rating it bestows upon the country from A2 to A3. When you consider that Bahrain's banks hold assets that amount to three times the country's gross domestic product, then you might concede Moody's has a point. But if you take into account the fact that Islamic - by which I mean Shariah compliant - banks have by and large fared well, relatively speaking, during the financial crisis, and that Bahrain's economy is forecast by no lesser an authority than the IMF to grow by 4.6 percent this year, as opposed to two percent last year, Moody's assessment seems harsh.

Most Gulf countries predicate their domestic fiscal budgets on an oil price of $40 to $50 a barrel. Anything more than that, as the kids say, is gravy. Moody's reckons Bahrain now needs the oil price to be around the $80 mark to balance the books, a state of affairs that it says also makes it cautious on the Kingdom's economic outlook. It points out that last year Bahrain had a budget deficit of 7.3 percent of GDP, although it does concede this is likely to narrow to 0.8 percent in 2010.

"Reduced fiscal flexibility makes it more challenging potentially to meet contingent liabilities arising from Bahrain's financial sector, which is relatively large compared with the government's resources," Moody's said.

But given the above, I don't think Moody's new rating for Bahrain is a verdict so much on the GCC's smallest member's economy so much as a sign of flagging confidence in Islamic banking. How else to explain downgrading a country whose fortunes are so reliant on the sector? Most people believe the oil price will remain high in 2011, but whether it does or not is academic as far as Moody's assessment goes, unless the state should need to step in to bail out its banks.

A3 is still an investment grade rating, but the lowering does beg the question - what does Moody's know about what awaits Islamic banks in 2011 that we don't?

Damian Reilly is the editor of Arabian Business.