What drove Gulf neighbors to bail out Bahrain?
In early October, news broke that Bahrain had reached a financial support agreement (FSA) with Saudi Arabia, Kuwait and the United Arab Emirates, with the first tranche expected to be transferred before the end of the year. The deal should help to alleviate Bahrain’s distressed financial sector and support the country’s currency peg, following deteriorating macroeconomic fundamentals after years of suppressed oil prices and exacerbated by extreme volatility in emerging markets this year. The consequent low level of international reserves and dire fiscal situation have sparked fears among investors over the country’s ability to service its debt and to maintain the peg.
How did this come about?
Despite some economic reform of recent years, Bahrain’s economy remains extremely dependent on its oil revenues, which still constitute 85% of Bahraini budget revenues according to the CIA World Factbook. Consequently, when global oil prices plummeted between 2014–2017, Bahrain’s fortunes swiftly skydived in tandem. The sizeable current account surplus swung to a large deficit, bond yields and the country’s credit default swap spiked. By the end of the third quarter of 2018, public debt had risen to 88.4% of gross domestic product and the country’s international reserves plunged to USD 1.5 billion—a mere one month of imports—from USD 5.7 billion in 2014.
Unlike its regional and oil exporting peers, the kingdom was not able to benefit much from the oil price rally earlier in the year—which saw prices surpass the USD 86 per barrel mark in early October before crashing back to USD 57.5 per barrel on 30 November. This is because Bahrain holds the lowest oil reserves in the Middle East and North Africa, with reserves estimated to be around 125 million barrels per day according to the U.S. Energy Information Administration. Even though the country receives a portion of the revenues from a Saudi offshore oil field as per a 1958 agreement, it has little control over the production output and thus pumps just 40,00 barrels per day, with little capacity to ramp up production when prices are high. Although a big oil field was discovered in April, analysts believe that it could prove too costly to extract the crude, while doubts have arisen over the amount of the newly-discovered reserves.
Exacerbating matters, Bahrain has the second-highest fiscal break-even point among oil exporting countries, at around USD 112.3 per barrel a year during the middle of the oil price slump in 2015-2017. Bahrain’s fiscal break-even point this year is estimated by the IMF to be USD 110.4 per barrel and a still-high USD 108.1 per barrel next year. Unless oil prices surpass the this price point—which is unlikely given recent data on U.S. production and some temporary sanction waivers on Iranian exports—Bahrain’s fiscal woes will likely continue in the absence of a shift in economic policy. Given the high fiscal break-even point amid multi-year low oil prices, the Gulf Cooperation Council will want to see fiscal reforms and expenditure cuts from the kingdom in return for financial assistance.
A Gulf Cooperation Council deal for Bahrain: A permanent solution or just a Band-Aid?
Although Bahrain is expected to receive the first tranche of aid money before the end of this year, investors will keep a close watch on the kingdom to gauge its commitment to fiscal adjustments. The deal was reached on the conditions that Bahrain will achieve a neutral budget balance in 2022 and reduce the public debt ratio from next year through spending cuts, utility tariff hikes and increasing non-oil revenues. One of the measures to raise revenue is the scheduled implementation of a 5% value-added tax. The VAT was originally supposed to be implemented on 1 January 2018, but the plan was shelved indefinitely due to parliamentary opposition; following the FSA, parliament approved the implementation of the VAT on 7 October and it will come into effect on 1 January 2019.
Bahrain’s commitment to the fiscal adjustments as part of the deal will greatly determine market confidence in the country’s ability to service its debt and its currency peg. Progress on finalizing the deal was slow and this likely highlighted the Gulf Cooperation Council’s reluctance to continue to commit funding unless Bahrain demonstrated a commitment to economic reforms.
Even so, geopolitical factors suggest Saudi Arabia will continue supporting the financial package irrespective. After all, Bahrain is led by a Sunni monarchy in a predominately Shia country; a sharp economic crisis in Bahrain could trigger severe political unrest and a shift in Bahrain’s top leadership with the likely appointment of a new Shia-led government backed by Saudi Arabia’s archrival Iran. Moreover, Bahrain is a stone’s throw from crucial Saudi oil infrastructure and has a land border with Saudi Arabia. It should thus come as no surprise that Saudi Arabia has a long track record of backing Bahrain in international conflicts.
What motivated Bahrain’s Gulf neighbors to execute the bail out?
The slump in oil prices after 2014 battered Bahrain’s economy. International reserves all but disappeared, the public debt ratio skyrocketed and the sustainability of the Bahraini currency peg was brought into question. Given that the latter’s collapse could have significant spillover effects for the wider region—most notably Saudi Arabia—it is not surprising that a Saudi, Kuwait and UAE coalition agreed on a financial aid package with Bahrain. The financial support and expected subsequent economic reforms should enable authorities to keep the currency peg in place.
All told, regardless of progress with stipulated economic reform, it is likely that Saudi Arabia will continue to support Bahrain to safeguard its own interests, and especially so that Iran cannot extend its sphere of influence so close to important Saudi oil infrastructure. All eyes will now be on Bahrain’s upcoming 2019 draft budget to gauge the government’s commitment to economic reforms and fiscal sustainability.
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Author: Jan Lammersen, Economist
Date: December 6, 2018
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