IMF Executive Board Concludes 2007 Article IV Consultation with the Kingdom of BahrainPublic Information Notice (PIN) No. 08/39
March 26, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On February 11, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kingdom of Bahrain.1
Bahrain's macroeconomic performance during 2005-06 was strong. Real GDP grew by 7¾ percent a year reflecting a strong expansion in financial services, construction, and manufacturing. This performance was supported by prudent macroeconomic policies, further improvements in the investment environment, and favorable economic conditions in neighboring countries. While non-oil GDP grew by 10 percent a year, oil GDP declined by 5 percent a year. As a result, Bahrain remains the lowest oil-dependent economy in the Gulf Cooperating Council (GCC), with the share of the hydrocarbon sector in total GDP declining to 15 percent in 2006. Inflation remained subdued at below 3 percent during in 2005-06, and the unemployment rate declined from 15 percent in 2005 to 4 percent in mid-2007. Financial stability has not been affected by the correction in the GCC equity markets or the recent global subprime credit turmoil.
The overall fiscal position registered moderate surpluses in 2005-06, as increases in oil revenues were largely offset by lower non-oil receipts and higher capital spending. Capital expenditures increased by over 2½ percent of GDP, but restraint in current spending helped maintain an average overall fiscal surplus of about 3 percent of GDP. As a result, public debt declined by 5 percentage points, to 23 percent of GDP by end-2006.
High oil prices have helped to strengthen the external position, as indicated by record-high current account surpluses. Despite strong import growth, the current account surplus averaged 12 percent of GDP in 2005-06, driven mainly by growth in exports of hydrocarbon products and aluminum. At the same time, the central bank's gross official reserves increased to about US$3 billion by end-September 2007, equivalent to 2.9 months of imports of goods and services. Bahrain's real effective exchange rate depreciated by 2.8 percent in 2005 and by an additional 2.9 percent in 2006, reflecting the weakening of the U.S. dollar.
Money growth accelerated in response to large foreign assets accumulation and strong private sector credit growth. Broad money grew by 15 percent in 2006, and at an annualized rate of 31 percent in the first nine months of 2007, with credit to the private sector growing at a strong pace. Following the cut in the Fed funds' rate in September 2007, in November 2007 the central bank lowered its key policy interest rate to ease upward pressure on the dinar.
Financial sector performance and the legal framework continued to improve. Solvency, profitability and asset quality indicators strengthened in 2006 and the first nine months of 2007. At the same time, the equity market remained remarkably stable during the GCC equity market turmoil of 2005-06 and strengthened subsequently, with the price index rising to a historical high after a 15 percent gain. The passage of a new Central Bank of Bahrain (CBB) law in September 2006 established the CBB as a single regulator of the country's financial services industry, covering banking, insurance, and the capital markets. The authorities have also made good progress in implementing the 2005 Financial Sector Assessment Program (FSAP) recommendations, including those pertaining to Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT).
The authorities have also embarked upon comprehensive reforms to further reduce the costs of doing business by streamlining regulations and creating the necessary infrastructure in partnership with the private sector. They have initiated a public services outsourcing and deregulation program, and have embarked on a four-pillar labor reform process to enhance productivity and employment opportunities and on a comprehensive overhaul of the education system.
The outlook for 2007-08 remains favorable. Reflecting a strong expansion in the non-oil sector, real GDP growth is projected to average 6½ percent a year in 2007-08. Inflation is expected to reach 3½ percent in 2007, but would decline gradually thereafter as world non-fuel commodity prices decline, and domestic supply bottlenecks subside. The overall fiscal surplus is projected to average 2¾ percent of GDP in 2007-08, owing mainly to higher oil revenue, while the external current account is expected to register record-high surpluses, on the order of 15 percent of GDP.
Executive Board Assessment
Executive Directors commended the Bahraini authorities' prudent macroeconomic policies and progress with structural reforms, which, together with the sharp increase in oil prices, have resulted in Bahrain's robust macroeconomic performance. Directors noted that a key medium-term challenge for the authorities will be to boost long-term economic growth while maintaining macroeconomic stability and reducing the economy's dependence on oil and vulnerability to oil price swings. They stressed that this will require continued steadfast implementation of structural reforms to further develop the non-oil sectors of the economy.
Directors commended the Bahraini authorities for maintaining fiscal prudence in the face of mounting social pressures to increase subsidies and transfers. They observed that although the fiscal position looks sustainable in the near to medium term, longer-term fiscal sustainability hinges on continued progress in diversifying the revenue base, containing current expenditure, and strengthening public financial management. They supported the planned introduction of value added, corporate, and excise taxes. Directors commended the creation of a Future Generation Fund to promote inter-generational equity in the use of Bahrain's natural resource wealth, and encouraged transparency and accountability in the management of the Fund.
Directors welcomed the authorities' commitment to further diversifying the economy, enhancing productivity, and reducing unemployment. They commended the ongoing public sector reforms aimed at fostering efficiency and private investment in the non-oil sectors of the economy, including the use of outsourcing and public-private partnerships. Directors encouraged the authorities to press ahead with their plans to strengthen public expenditure management, including through the implementation of program-based budgeting, and welcomed the steps being taken to close the actuarial gaps of the two public pension funds.
Directors observed that inflation remains low despite a recent slight increase due to regional supply bottlenecks and the depreciation of the U.S. dollar. They encouraged the authorities to continue strengthening liquidity management, and to further liberalize the economy in order to increase competition and address supply bottlenecks. Directors also advised that public spending be cut back if inflationary pressures were to develop.
Directors welcomed the positive assessment of the health of Bahrain's financial system. They supported the authorities' plan to preserve Bahrain's financial center competitiveness by providing niche financial services, particularly in Islamic banking and insurance, in the context of a first-class regulatory and supervisory framework. They congratulated the authorities on the prompt implementation of the 2006 FSAP recommendations and encouraged them to strengthen oversight over banks' exposure to the construction and real estate sectors.
Most Directors agreed that the Bahraini dinar's peg to the U.S. dollar has served Bahrain well, and is broadly in line with economic fundamentals. They noted that the current account surplus, though at present higher than its medium-term norm, is expected to decline gradually in the coming years owing to strong growth of domestic demand. Directors saw merit in the authorities' decision to keep the peg to the U.S. dollar in the run up to the GCC monetary union. They were encouraged that, as of end 2006, Bahrain had observed all of the GCC convergence criteria.
Directors encouraged the authorities to steadfastly pursue their four-pillar labor market reform strategy aimed at stimulating investment and technological change, enhancing education and on-the-job training, and investing in skill-building programs to boost productivity. They cautioned, however, that labor market reforms should be appropriately prioritized and phased to dampen any adverse impact on Bahrain's competitiveness. Directors commended the authorities for the progress made in reducing the cost of doing business in Bahrain.
Directors welcomed the authorities' commitment to strengthen Bahrain's national statistical framework and to subscribe to the IMF's General Data Dissemination Standard (GDDS). They encouraged the authorities to finalize the GDDS subscription process with technical assistance from the IMF.