Public Information Notice No. 04/96

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Kingdom of Bahrain

August 24, 2004

On June 14, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kingdom of Bahrain.¹

Background

Endowed with smaller oil resources than its neighbors, Bahrain established a policy of openness and diversification early on and has become one of the most advanced economies in the region with liberal exchange rate, trade, and investment regimes. Macroeconomic performance has fared well relative to the other countries of the Gulf Cooperation Council (GCC). Diversification efforts have resulted in the development of non-oil activity in manufacturing (in particular, aluminum) and various nonfinancial services, including tourism. In addition, efforts to establish Bahrain as a regional banking and financial services hub have had notable success.

Despite diversification efforts, however, Bahrain's economy remains heavily dependent on oil and gas. Moreover, rapid population growth, combined with labor market rigidities and shortage of marketable skills have resulted in unemployment among Bahraini nationals. Public sector wages and benefits are among the highest in the region.

Recent macroeconomic performance has been strong, with real GDP growth exceeding 5.5 percent in 2003, up from 5 percent in 2002. Non-oil growth performance rose from about 6 percent in 2002 to 6.5 percent in 2003, underpinned by strong growth in manufacturing (mainly aluminum) and financial services. Prices increased only slightly (by about 1 percent). Broad money rose by 6.4 percent in 2003 on account of a 9 percent increase in credit to the private sector, while velocity remained stable. Reflecting growing confidence in the economy, in part due to higher oil prices and low interest rates, the Bahrain stock market produced sizable returns, growing by 28 percent in 2003.

The consolidated fiscal position improved and registered an overall deficit of 1.8 percent of GDP in 2003, largely on account of higher oil prices. While the share of total expenditure relative to GDP has varied significantly in recent years, capital spending has increased in 2002-03. Notwithstanding higher oil prices, the external current account position was estimated to have registered a deficit in 2003. The increase in crude oil imports was more than offset by higher exports of refined products. Non-oil exports were relatively flat while imports rose by 17 percent. Service receipts were strong, mostly on account of additional tourism revenues.

There has been recent progress in the area of structural reforms. The government has completed privatization of the country's public bus network, liberalized the telecommunication industry, and set up the regulatory authority in 2003. Legislation to enhance the transparency of privatization procedures was also passed in 2003. Progress in privatization of public utilities has been slow, however, due to concerns of increasing unemployment, although plans are under way to involve the private sector in the operation of the newly built Hidd power generating project.

Unemployment remains a concern. The authorities have adopted active labor market policies of matching job seekers with potential private sector employers and promoting acquisition of marketable skills through training. A draft Labor Law is being discussed with labor unions and the private sector that emphasizes vocational training and stipulates equal benefits for public and private sector employees. The introduction of a minimum wage is being considered.

Finally, the financial sector remains one of the main engines of growth for Bahrain's economy and one of the most vibrant in the region. To ensure effective supervision and mitigate risks common across the components of the financial sector, the Bahrain Monetary Agency (BMA) has consolidated the supervision and regulation of the financial sector (including banks, insurance, and capital markets) under one umbrella. Bahrain is at the forefront in developing Islamic financial services.

Executive Board Assessment

Executive Directors commended the Bahraini authorities for their prudent management of the economy, which has resulted in consistently high GDP growth, low inflation, a manageable debt situation, and positive social and development indicators. They endorsed the authorities' strategy to improve the country's competitiveness and growth prospects through continued openness, diversification away from oil and gas production, and institution building. The most notable success has been in the financial sector where, through appropriate regulations and innovations in conventional and Islamic finance, Bahrain has become a regional hub.

Directors considered that the main challenge over the medium term will be to build on earlier successes by sustaining non-oil growth and creating employment opportunities for the growing Bahraini labor force. This will require further progress in key structural areas, in particular, reducing the role and size of the public sector while encouraging private sector development and investment, eliminating rigidities, particularly in the labor market, as well as continued adherence to principles of good governance in public sector institutions and the corporate sector.

Directors commended the authorities for their commitment to maintaining a prudent fiscal policy. They noted that in the 2004 budget, increases in capital expenditures for infrastructure modernization and utilities will be more than offset by increased revenues from oil receipts, and that a small fiscal surplus is to be achieved. For the medium term, Directors considered that the authorities' plan to scale back capital expenditure to contain any emerging macroeconomic imbalances should be complemented by fiscal reforms aimed at further strengthening fiscal institutions and enhancing the non-oil revenue base, thereby reinforcing growth and diversification efforts. Directors agreed with the authorities' thinking that in reaching for the goal of medium-term sustainability, the pre-eminence of the further development of human capital and investments in strategic infrastructure would need to be respected. Directors welcomed the intention to establish an oil stabilization fund by the end of the year, in order to preserve hydrocarbon wealth for future generations. In this context, a few Directors expressed the view that to safeguard intergenerational equity, expanding the economy's productive base and developing human resources will be as important as accumulating financial assets.

Directors agreed that adopting a broad-based consumption tax (preferably, a value-added tax) should ideally be carried out in the context of a future coordinated tax regime under the Gulf Cooperation Council (GCC). Nevertheless, they encouraged the authorities to start laying the foundations for such a tax, and to adjust various fees and charges to reflect costs more closely. As regards expenditures, Directors cautioned that the public sector wage bill has risen sharply in recent years, and welcomed steps taken by the authorities to contain it in order to promote medium-term fiscal sustainability and strengthen the budget's capacity to withstand oil price shocks. They concurred with the authorities' plans to downsize and streamline the public sector, including by outsourcing some government services.

Directors considered that the current peg of the dinar to the U.S. dollar is appropriate and has served the economy well. They welcomed the increased monetary cooperation and harmonization under way in the context of the GCC, with the objective of achieving monetary union by 2010.

Directors supported the authorities' efforts to further improve prudential practices in the financial sector through consolidation of supervision under the authority of the Bahrain Monetary Authority. They observed that ensuring that there is an adequate number of suitably trained financial supervisory staff to handle the broadening range and increasing sophistication of financial products and services will be a constant challenge and priority. Directors welcomed the authorities' intention to undertake an Financial Sector Assessment Program (FSAP).

Directors considered appropriate the authorities' focus on liberalization and structural reforms aimed at promoting private sector-led growth and creating job opportunities. They welcomed the privatization of the public transport company, and the intention to privatize the postal and port management services. They encouraged the authorities to press ahead with their structural reform agenda to promote wider private sector participation, including through further privatization in the infrastructure and utilities sectors. Eliminating remaining barriers to foreign ownership of commercial assets will provide additional impetus for foreign investment in the non-oil sector. Directors welcomed the authorities' fruitful trade liberalization efforts, including in the context of the Greater Arab Free Trade Area, and other pending and recently concluded free trade agreements. They noted that such efforts, as well as progress toward the implementation of best international practices in the areas of corporate governance, anti-money laundering, and combating the financing of terrorism—including Bahrain's taking a leadership role in establishing a regional body to monitor these activities—will open new markets and encourage direct investment.

Directors welcomed the emphasis placed in the authorities' program to reduce unemployment among Bahraini nationals on vocational training and initiatives to unify benefits in the public and private sectors, to make private sector employment more attractive. Regarding the possibility of introducing a minimum wage, Directors felt that a minimum wage, if set at too high a level, could impede efforts to reduce unemployment and affect competitiveness. They encouraged the authorities to use price- and market-based interventions to encourage employment of Bahraini nationals. They advised that if unemployment insurance is introduced, it should be designed so as to minimize its impact on the budget and on work incentives.

Directors welcomed recent improvements in data provision, but recommended a further strengthening of Bahrain's statistical systems, in particular concerning dissemination to the public of comprehensive, timely, accessible, and reliable economic and financial statistics.

Directors encouraged early participation by Bahrain in the General Data Dissemination System.