IMF Executive Board Concludes 2009 Article IV Consultation with BahrainPublic Information Notice (PIN) No. 09/112
September 9, 2009
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 May 22, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Bahrain.1
The ongoing financial crisis affected Bahrain’s economy in 2008. Real GDP growth declined to 6 percent, from 8 percent in 2007, owing to a deceleration in non-oil activity associated with a drop in financial services. Despite pressures in the region during 2007–08, inflation has remained contained relative to other Gulf Cooperation Council countries, partly reflecting government subsidies and infrastructure development projects that have helped to limit housing bottlenecks.
Global financial developments also had an impact on Bahrain’s external position in 2008. The appreciation of the U.S. dollar generated a reversal of speculative capital inflows. Some locally-incorporated banks incurred losses on their international securities portfolios and experienced a sharp decline in deposits, but parent banks or shareholders brought in some capital and increased deposits or credit lines. Overall, these resulted in a balance of payments deficit, with gross international reserves declining from 7½ months of imports in 2007 to 5½ months in 2008.
Buoyant hydrocarbon revenues financed a strong increase in public spending in 2008. The fiscal stimulus continued in 2008, with the non-oil primary deficit increasing to 33 percent of non-oil GDP, from 27½ percent in 2007. The rise in spending reflected higher current outlays; capital spending declined. The 2009 budget foresees an increase in the non-oil primary budget deficit of 1½ percentage points of non-oil GDP, as higher current spending is expected to more than offset a further decline in capital expenditure.
A decline in net foreign assets after July 2008 contributed to a deceleration in the expansion of broad money, but credit growth remained high at end-2008. Net foreign assets increased during the first half of 2008, owing to high oil prices and speculative capital inflows. Despite the introduction of higher capital charges on real estate investments in 2007 and an increase in reserve requirements from 5 to 7 percent in January 2008, banks continued to channel significant resources to domestic lending, further fueling credit growth to the private sector. A decline in net foreign assets since July 2008 contributed to a slowdown in broad money growth to 18½ percent by year’s end. Nevertheless, the 12-month growth of credit to the economy remained high at 37 percent in December 2008.
The financial sector has so far withstood the global turbulence, reflecting in part the strength of sovereign shareholders. The global shrinkage in bank balance sheets has affected wholesale banks, given their dependence on deposits and funding from the global interbank market. However, despite the magnitude of financial flows relative to the size of the economy, the CBB has not had to take drastic action to shore up retail banks, mainly because parent banks and/or shareholders have provided support to buttress solvency and liquidity. Consequently, liquidity has been maintained in the system and core retail banks have been able to preserve their balance sheets.
Worldwide deleveraging, lower oil prices, and the global recession are expected to further slow down growth in 2009. Those banks that were stabilized by sovereign shareholders are expected to withstand the second round impact of the crisis, while others for which real estate or private equity asset valuations are still in flux may run losses. Real GDP growth is projected to slow to 2½ percent mostly due to a contraction in the wholesale banking sector and stagnation in oil output. The drop in oil prices is expected to reduce the external current account surplus and result in a fiscal deficit.
Executive Board Assessment
Executive Directors commended the Bahraini authorities’ prudent macroeconomic policies and strong financial oversight, which have contributed to Bahrain’s robust macroeconomic performance and to the resilience of the financial sector in the face of the global financial crisis. At the same time, Directors noted the downside risks to the economic outlook stemming from the sharp decline in oil prices, the credit crunch, and asset price deflation. They emphasized that the key challenges faced by the authorities are to safeguard financial stability and mitigate the impact of the global downturn on the domestic economy.
Directors commended the Central Bank of Bahrain’s effective response to the global financial crisis, including the monitoring of interbank exposures and roll-over risk, provision of liquidity, and the design of a crisis preparedness framework. They encouraged continued vigilance, especially in light of Bahrain’s open capital account, the large weight of the financial sector in the economy, and close linkages with the global financial system.
Directors supported the measures taken by the authorities to address the vulnerabilities arising from the recent rapid bank asset growth and concentration in real estate. They welcomed the intention to complement these measures with additional provisions, with the view to limiting bank exposure to real estate. Directors encouraged the authorities to accelerate the implementation of the remaining recommendations of the 2005 Financial Sector Assessment Program (FSAP).
Directors supported the easing of monetary policy to protect growth and the exchange rate peg. They agreed that the fixed exchange rate has served Bahrain well, especially by helping to keep inflation low. They noted the staff’s finding that the Bahraini dinar is broadly in line with economic fundamentals. They endorsed the authorities’ decision to keep the peg to the U.S. dollar.
Directors commended the authorities’ commitment to fiscal prudence and medium-term fiscal sustainability. They noted that lower extra-budgetary spending for 2009–10 may result in a procyclical fiscal stance. Most Directors emphasized the need to ensure at least a neutral fiscal stance to avoid a further weakening of economic activity in the face of the global downturn, and some Directors favored a counter-cyclical stance in view of Bahrain’s low level of indebtedness. In this connection, Directors supported the authorities’ contingency plan to reactivate delayed investment spending if oil prices were to rebound above the budget price. Directors stressed, however, that a balance needs to be struck between preserving fiscal sustainability and maintaining growth, and encouraged the development of a medium-term fiscal framework.
To ensure medium-term fiscal sustainability, Directors stressed the need to diversify the revenue base, and supported the planned introduction of a value added tax, corporate income tax, and excises to reduce the budget’s dependence on oil revenue. Directors also emphasized the importance of containing current spending, including by linking salaries and benefits to performance and merit and gradually phasing out subsidies, in particular those on electricity and fuel.
Directors welcomed the authorities’ commitment to address Bahrain’s infrastructure needs. They encouraged the authorities to press ahead with their plans to strengthen public expenditure management in order to ensure an appropriate prioritization of investment. Directors recommended a cautious and gradual approach in implementing investment projects through public-private partnerships, until appropriate capacity to assess risk is built.
Directors encouraged the authorities to pursue their labor market reform strategy aimed at stimulating technological change, enhancing education and on-the-job training, and investing in skill-building programs to boost productivity. They pointed out that labor market reforms should be appropriately calibrated and phased to dampen any adverse impact on Bahrain’s competitiveness.
Directors welcomed the authorities’ commitment to strengthen the statistical framework, reflected in Bahrain’s participation in the Fund’s General Data Dissemination System. They encouraged the authorities to increase the resources available for this purpose.