Public Information Notice No. 13/53

Public Information Notice: IMF Executive Board Concludes 2013 Article IV Consultation with the Kingdom of Bahrain

May 15, 2013

On May 1, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation¹ with the Kingdom of Bahrain, and considered and endorsed the staff appraisal without a meeting on a lapse-of-time basis².

Background

The economic situation improved in 2012 following the downturn in non-oil GDP in 2011 due to the crisis in the euro area and domestic political unrest. Oil production for the year contracted because of a disruption in the Abu Saa’fa field that normalized by end-2012. However, non-oil economic activity rebounded, supported by government spending, and the rebound was broad based. Activity in manufacturing, hotels and restaurants, and insurance picked up significantly, accompanied by a moderate recovery in construction and retail banking. Inflation is again in positive territory after the 2011 deflation, supported by a pickup in housing rents.

The external position improved in 2012 due to a decline in capital outflows, and the current account position remained strong with an estimated surplus of 18.2 percent of GDP. Official reserves increased from $4.2 billion at end-2011 to about $4.9 billion in 2012 (18 percent of GDP and close to 10 months of import cover, excluding imports of crude oil). Currency forward premia show no signs of pressure on the exchange rate.

Financial market developments reflect the rebound in the wider economy. Private-sector credit and deposit growth were solid at 6 percent and 5 percent, respectively. In addition, there are tentative signs that investor confidence has improved. The deleveraging in the wholesale segment of the banking sector appears to have stabilized, and several market-based indicators have moved into more positive territory. The government’s most recent bond issue of $1.5 billion was four times oversubscribed at a coupon of 5.8 percent; both bond yields and CDS spreads are now back to pre-2011 levels. In January 2013, Standard & Poor’s revised Bahrain’s outlook to stable from negative. Nevertheless, the stock market index declined by 7 percent in 2012.

The fiscal outcome in 2012 is estimated to have been better than expected. The overall fiscal deficit for 2012 (excluding extra-budgetary operations) is estimated at 1.0 percent of GDP, reflecting high oil prices, a consolidation in capital spending, and a reduction in subsidies and transfers that resulted from scaling back gas subsidies for industrial users. Including extra-budgetary operations, the overall deficit is estimated at 2.6 of GDP.

Executive Board Assessment

In concluding the 2013 Article IV consultation with the Kingdom of Bahrain, Executive Directors endorsed staff‘s appraisal, as follows:

The economic outlook depends on progress on the domestic political front, and is subject to oil price risk. Economic activity improved following the 2011 downturn. However, in the absence of an enduring political solution, private sector investment is expected to remain weak, implying only moderate non-oil growth, below 4 percent in 2013 and over the medium term. At the same time, Bahrain’s fiscal breakeven price has reached critical levels—$115 in 2012—rendering Bahrain vulnerable to a sustained decline in oil prices. Gradual fiscal consolidation, accompanied by strengthening the investment climate, will be key to restoring high levels of private sector–led growth and employment creation for nationals.

The short-term policy stance is expected to remain supportive of economic activity. Monetary policy and liquidity conditions remain appropriately supportive of a strengthening of private-sector credit growth. Policy interest rates are expected to remain low, reflecting free capital mobility, the peg to the U.S. dollar, and low U.S. interest rates. Inflation is expected to remain subdued, at around 2.3 percent. Compared to 2012, there is likely to be a fiscal stimulus of 2.1 percentage points of non-oil GDP in the non-oil primary deficit and the deficit will remain significantly above its 2008 pre-global financial crisis level. Given the pressing need for fiscal consolidation in light of fiscal sustainability concerns, staff recommends fiscal adjustment of 1.2 percentage points of GDP in 2013, which would still provide for a fiscal stimulus of 0.9 percentage points of GDP. The exchange rate is broadly in line with fundamentals and staff supports the authorities’ intention to maintain the peg to the U.S. dollar in the run-up to the Gulf Cooperation Council monetary union.

The overarching economic challenge is to diversify the economy away from oil production.
To achieve the authorities’ economic objectives under Vision 2030, it is essential to adopt a multifaceted strategy with a focus on generating high value–added exports and employment opportunities for nationals. Policy action should focus on improving the legal infrastructure to support private-sector activity; enhancing educational quality and vocational training, including training for the female labor force; providing an enabling environment for the development of a diverse manufacturing industry; enhancing FDI to support technology diffusion; further harmonizing business and tax regimes within the Gulf Cooperation Council; and expanding exportable services in the financial and tourism industries.

Fiscal consolidation is essential to stabilize debt in the medium term. Despite the better-than-expected budget deficit in 2012 of 2.6 percent of GDP—the result of higher oil prices, capital spending consolidation, and the reduction of gas subsidies for industrial users—and the expected disbursement of the Gulf Cooperation Council funds (to start in 2013), the fiscal situation poses sustainability concerns. Overall fiscal deficits are projected to widen and public debt is estimated to continue on a rising path that could become unsustainable, reaching 61 percent of GDP as early as 2018. There is therefore an urgent need for a gradual fiscal consolidation over the next three two-year budget cycles, of about 7.7 percent of GDP, in order to stabilize government debt at 40 percent of GDP over the medium term. Despite commendable efforts by the MoF to raise non-oil fiscal revenues through fee increases and other measures, halting the fiscal deterioration and putting government debt on a sustainable path will depend critically on the adoption of measures that have high fiscal saving potential; there is now an urgent need to initiate a medium-term fiscal strategy with a view to adopt a gradual retargeting of subsidies, contain public-sector wage increases, increase non-oil revenues, rationalize capital expenditures, and place the pension fund on a sustainable path.

Plans to strengthen the medium-term fiscal framework are welcome. Staff supports the authorities’ plans to establish a debt management office under the Ministry of Finance. In addition to providing impetus to financial market development, strategic debt management will help contain interest rate costs at a time of rising public-sector borrowing needs and lower rollover risks. The authorities are also interested in establishing a macro-fiscal unit, which could support medium-term fiscal planning. The authorities expressed their interest in receiving technical assistance from the Fund in both areas.

The banking sector is in good health, but staff recommends the buildup of additional cushions in vulnerable banks to reduce risks. The size of the financial sector remains a key structural vulnerability of the banking sector. Wholesale banks’ assets equal 480 percent of GDP and retail banks’ assets total 270 percent. To date, swings in international banking flows, especially the contraction of wholesale banks, have only affected Bahrain via associated job losses. If deleveraging pressures were to re-intensify in international markets, there could be additional spillovers, although limited, to domestic banks through interbank linkages. Stress tests indicate that the large wholesale segment is resilient to credit shocks, but there are pockets of vulnerabilities in the retail segment, particularly in Islamic banks because of their concentrated exposures to local and regional real estate. Risks in vulnerable banks could be ameliorated by the buildup of additional capital cushions through earnings retention. Ongoing efforts to further strengthen the regulatory and supervisory regimes are welcome, including the planned adoption of the Basel III capital and liquidity frameworks, the designation of domestically systemically-important financial institutions, and moving the existing deposit insurance scheme to a pre-funded system.