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Wed 19 Aug 2015 10:56 AM

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FOCUS - Bahrain’s fiscal tightrope: the island state's battle to regain lost ground

Once the region’s trendsetter, Bahrain has been falling behind its Gulf neighbours on numerous counts, as it struggles to recover from a domino effect of the economic downturn, political unrest and lower oil prices. But is the island kingdom really down and out?

FOCUS - Bahrain’s fiscal tightrope: the island state's battle to regain lost ground

Not so long ago, Bahrain was a haven for international investors. The kingdom was a financial hub with the region’s strongest commercial regulations and little strife.

But when the 2008-09 financial crisis hit, the island state was already losing significant ground, particularly to the new financial capital of Dubai, and unlike Qatar, the UAE and Saudi Arabia, it has struggled to make any significant turnaround since the global downturn.

The double setback of political unrest since 2011 has at times paralysed commercial activity and continues to affect investor confidence, particularly among those from outside the region.

Matters have been made even worse in the past year by the dramatic decline in the price of oil; the commodity accounts for 90 percent of state revenues and — again — unlike its neighbours, Bahrain does not have large sovereign reserves to fall back on.

The spiralling predicament has left it with a fiscal deficit expected to balloon to $4bn this year and slightly more in 2016, according to the budget approved in July. The total deficit for 2015-16 is $74m more than originally accounted for and almost double that anticipated in the 2013-14 budget. “Bahrain is walking a fiscal tightrope,” the Economist Intelligence Unit’s Pat Thaker says.

“While approval of the budget, backdated to January, paves the way for the release of government funds for new public projects, the current fiscal position is unsustainable. Further austerity measures are expected, including subsidy cuts and increased taxes on government services, although the overall impact [of any increased taxes or subsidy cuts] is likely to be fairly small, at least in the short term.”

The country raised its debt ceiling from $13.27bn to $18.58bn in November last year, allowing it to bankroll public spending through additional borrowing despite concerns over its credit rating.

Public debt is expected to reach 70 percent of gross domestic product (GDP) by the end of next year, compared to 46 percent at the end of 2014, according to credit ratings agency Moody’s, far higher than the other GCC states.

Moody’s downgraded Bahrain’s long-term government debt rating to Baa3 from Baa2 in April, and its outlook is negative. In July, the country’s banking system — once a stalwart for the region —  was downgraded to negative from stable, with Moody's saying that a slowdown in Bahrain’s economic growth will weigh on the banks’ funding and profitability over the next 12-18 months.  It expects economic growth to contract from 4.5 percent in 2014 to 2.7 percent in 2015.

The Economist Intelligence Unit sets an even bleaker picture, with growth projected to fall below 2 percent this year, recovering to an average 3.2 percent before rising to 4.2 percent in 2019 as new aluminium and refinery capacity comes on stream.

Amid the overall economic slowdown, state-owned Aluminium Bahrain (Alba) has increased its production to a record 931,427 metric tonnes and has announced additional capacity plans. A shining light in the country, Alba is one of the largest industrial companies in the Middle East and one of the top ten largest aluminium producers in the world.

The Bahraini government is also seeking to raise alternative revenue by taxing households and private businesses and reducing its $2bn subsidies programme. On 7 July, it announced plans to charge for sewerage services currently provided for free. However, a similar initiative to scrap red meat from the subsidies list from as early as this month was scuttled by some MPs who feared a backlash among their constituents, despite a caveat that would have likely seen citizens given cash handouts to make up for the increased prices.

Any form of subsidy reform is politically contentious, and that in a country already facing ongoing political conflict that has all too often caused bloodshed on the streets during the past four years. Comparatively, the UAE — in a far healthier fiscal position — has successfully increased fuel prices by 24 percent with little internal criticism.

The political difficulty in cutting back spending has weighed on minister of finance Sheikh Ahmed Bin Mohammed Al Khalifa, who described the budget passed by parliament on July 5 as being “the most difficult budget that we have had to deal with in the past 12 years”.

“We have to realise the more we borrow, the more our currency gets devalued, so we have to be content with what we have and spend according to capabilities,” he was quoted as saying by local newspaper Gulf Daily News.

Bahrain could once call on foreign investors to help prop up its spending on large infrastructure projects but that too has shrunk in recent years, to $957m in 2014, compared to $989m in 2013 and the $1.8bn the kingdom attracted in 2008, according to the United Nations Conference on Trade and Development’s World Investment Report.

Robert Lee, the former head of a major government development project, Bahrain Bay, says the country is lacking a coherent goal.

“I think what’s clearly needed is a clarity of vision,” Lee, also a former executive of Dubai developer Emaar, says. “That seems to not be communicated clearly. What does Bahrain represent? What does it mean? Bahrain 10-15 years ago was very clear about what it was; it created a financial centre for the area. But that game has come and gone. So what is the new game?

“Having clarity of that vision, then you have to be able to cater to it and put a substantial amount of capital for the next aspect of vision. I think that’s what’s been lacking in Bahrain. That’s what other regions have done better.

“I continue to believe that Bahrain, in the medium to long run is a great opportunity, a great place strategically and geographically and what it represents. [But] I think in the short term, it’s not as clear, which forces [only] people with very strategic vision or the willingness to take a greater risk to get into the real estate game in Bahrain.”

The government released its Economic Vision 2030 document in 2008, outlining various clearly defined and laudable targets and reforms, but progress has been slower than expected, due to the ongoing economic and political hurdles.

The Bahrain director of property consultancy CBRE, Steve Mayes, says those tensions have now been suppressed, but he still warns investors cannot ignore the issue.

“Any ongoing unrest in the kingdom has subsided into almost unnoticeable levels of activity and has been driven by the authorities away from the public eye and severely restricted to a point where it has no impact on daily life for business, residents or visitors,” he says.

“Property development requires long-term planning and the short-term events surrounding political unrest have had little, if any, impact on development plans.

“The geopolitical shift in the region and ongoing political tensions, however, cannot be ignored and investors would be well advised to factor these into their projections, as matters can quickly escalate, as witnessed previously.”

Bahrain has some of the most sound commercial structures in the GCC. The companies law provides for 100 percent ownership, while the initial capital investment required is lower than other Gulf states. It was also the first GCC state to reform its labour laws, in 2009, allowing expatriates to freely change jobs with three months’ notice and is one of only two Gulf states (the other is Oman) that enjoy a bilateral free trade agreement with the US. 

Lee says the more relaxed environment and lower cost of living also makes Bahrain more attractive for some business owners. However, there is “definitely room for improvement”, including greater protection for real estate buyers.

“The rule of law speaks volumes and I think that’s probably the next step that we’ll see in Bahrain,” he says.

But the elephant in the room remains political unrest, keeping away some investors, particularly from outside the Middle East.

“Bahrain’s reputation as a safe, stable financial hub has been severely damaged by political unrest,” Thaker says, adding the kingdom also is losing ground as Saudi Arabia and Dubai introduce increasingly sophisticated onshore financial regulation.

“[Bahrain] will progressively play the role of a financial ‘back office’ for its neighbours, providing legal and accounting services, as well as specialist financial services, such as Sharia-compliant products and fund management,” Thaker says.

She says Bahrain’s lack of hydrocarbon reserves, compared to its Gulf neighbours, will see it increasingly seek to attract foreign investment into a broader range of sectors, including manufacturing, finance, tourism, healthcare and information and communications technology (ICT).

It will maintain its liberal investment environment and continue to pursue more FTAs, although this time as a member of the GCC, which Thaker says should eventually add to Bahrain’s attractiveness for firms from those countries. The kingdom’s financial sector will additionally continue to benefit from the Central Bank of Bahrain’s strong regulatory reputation and its steps to improve regulation of the Islamic finance sector. Relatively high levels of internet connectivity and near-universal English-language skills also should support investment in ICT, while real estate is a mixed bag, she says.

“There is still some interest in inward investment in tourism and high-end real estate, but investment opportunities will be greater in affordable housing, which is currently undersupplied,” Thaker says.

Bahrain’s real estate market was flourishing in the years leading up to 2009, but unlike other countries that have since managed to claw back some value, the additional factor of social unrest has delayed the return of the residential and office sectors. “The residential sector remains flat and the commercial office market continues to suffer as supply outstrips demand,” Mayes says.

“Although the residential sales and residential leasing sector is not performing as well, it is gradually improving. The commercial office market, on the other hand, remains relatively subdued with little sign of a significant uptick in demand, especially as government budgets are being squeezed by lower oil revenues forcing ministries to contract, rather than to expand, as has been traditionally required for excess stock in the market to be absorbed.”

New legislation designed to protect buyers in new developments, as well as the restart of stalled projects, are expected to have a positive impact soon, Mayes says.

“This is likely to underpin market confidence, which should consolidate recent gains and generate market activity.”

Numerous high-profile five-star hospitality providers have also recently moved into the Bahraini market, including Four Seasons and Marriott (the latter’s JW Marriott Bahrain is due to open in 2016), both located in Bahrain Bay. International chef Wolfgang Puck has shown his vote of confidence in the kingdom, opening three restaurants within the Four Seasons hotel.

Mayes says the decisions by renowned hospitality brands are “inextricably linked” to the government’s policy of diversification and a drive to reposition the kingdom as an all-year round tourist destination that does not simply rely on events such as the F1 bonanza.

“This, coupled with a marked improvement in the security situation, has seen an 11 percent increase in visitor numbers with up to 1 million per month crossing from Saudi Arabia,” Mayes says.

“The investment made by globally recognised brands reflects renewed confidence in Bahrain and recognises the strategic location of the kingdom, situated between the two biggest economies in the Gulf. It is well positioned to take advantage of regionally significant infrastructure projects such as the Pan Gulf railway project and the Friendship Causeway, making the attractions of Bahrain’s liberal regime potentially even more accessible to huge numbers of new visitors.”

Most of the tourism growth is being propelled by Saudis. Tens of thousands cross the King Fahd Causeway daily for work and entertainment. The commute has grown so much there are plans to build a second bridge to help alleviate long delays at border crossings, as well as what would be the longest bridge in the world, stretching to Qatar in a bid to replicate a similar economic boom with another strong Gulf state. 

“You cannot ignore the impact of Saudi Arabia in everyday life in Bahrain. Traffic almost doubles once the weekend starts and the restaurants get busier,” Lee says.

The oil-rich kingdom — the wealthiest Middle Eastern country — also is something of a saviour for Bahrain’s economy and Sunni monarchy. Saudi Arabia and the UAE sent in troops to Bahrain to help quell unrest during 2011 and Saudi Arabia has regularly offered loans and funded various projects to ensure the stability of King Hamad Bin Isa Al Khalifa. Back in 2011, the GCC as a whole provided $20bn in funding to Bahrain and Oman, money which is being invested into major infrastructure projects in the kingdom.

Thaker says the relationship is only set to tighten. “Increasingly close cooperation with its larger neighbour, Saudi Arabia, is likely as Bahrain comes to rely more on its neighbour for both economic stability and internal security,” she says.

“Saudi Arabia is also a provider of foreign aid and is thought likely to be a lender of last resort to Bahrain in the event of an economic or financial crisis, as it regards the security of Bahrain as closely linked to its own national security. Similarly, Bahrain’s continued access to the international debt markets relies in part on the perception that Saudi Arabia will backstop the country if needed.”

With the support of such a powerful ally, it is unlikely Bahrain will fall by the wayside, but one thing is crystal clear: right now, the kingdom is falling short of its once-glorious potential.