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Country Economic Forecast: Bahrain

Highlights

* GDP grew by 4.6% in Q3, driven by the continued bounce-back in oil production as well as by strong growth in government spending and GCC aid. Growth in the first nine months of 2013 averaged 4.7%, with oil GDP up 12.2% and non-oil GDP rising by a much more modest 3%.

* After an estimated increase of 4.6% in 2013, we expect the economy to grow by just 3.5% in 2014. This slowdown will be entirely due to oil production levelling out. But non-oil sector growth is expected to accelerate to 4% from just over 3% in 2013, as it is beginning to benefit from the GCC aid being spent on the infrastructure programme. Much progress has been made in the waste-water sector and this will continue to be the case in 2014.

* But medium-term growth prospects are probably the poorest in the GCC. The outlook remains constrained by declining oil production trends, the continuing impact of high political risk on Bahrain's reputation as a regional centre and on economic confidence, and a lack of structural and fiscal reforms. The high and rising non-oil fiscal deficit is a big concern, albeit tempered by strong GCC and Saudi support.

* Although inflation data are acknowledged to be unreliable and fluctuate wildly, at 3.6% in November it appears under reasonable control. With favourable external factors and an absence of structural problems in the housing market, we expect inflation to average just 2.8% this year after 3.3% in 2013. But lower fuel subsidies are a risk factor.

Forecast Overview

Oil output and public spending...

Our 2013 GDP growth estimate has been raised to 4.6%, above both the market consensus of 4% and the IMF figure of 4.4%. The pick-up from 3.4% in 2012 reflects a stronger oil sector, together with the impact of faster growth in public spending than originally planned, GCC aid and a number of large industrial projects coming through.

...lifting growth above 4.5% in 2013

Q3 GDP grew 4.6%, driven by the continuing bounce-back in the oil sector as well as solid growth in some other parts of the economy, including the government sector and manufacturing. In the first nine months of 2013, GDP grew 4.7%, with oil GDP up 12.2%. The non-oil economy has recovered from the political troubles in 2011 to develop reasonable momentum, with 3% non-oil GDP growth in Q1-Q3. Activity in 2013 was driven by:

* Higher oil output - output from the Abu Saafa oilfield, which Bahrain shares with Saudi Arabia and relies on for some 75% of its crude, was well below normal for most of 2012 because of technical problems. With these difficulties resolved, crude output climbed by over 15% in H1 and is estimated to have risen by 10% for the full-year.

* Continued strength in government spending - following parliamentary approval of an extra BHD 174m, government spending is now forecast to rise by 12% in 2013. Also, a significant portion of the promised US$1 Obn of GCC aid is now flowing in, mainly from Saudi Arabia, Kuwait and the UAE. These are in the form of annual transfers over 10 years for housing, infrastructure, social services and industry.

* Political uncertainty - reconciliation talks between the Sunni-led government and the Shi'ite opposition have made limited progress. Indeed, the government has been hardening its response to any protests. The King has banned public gatherings in Manama and has announced tougher penalties for guardians of minors taking part in demonstrations. And under-age youths caught protesting are being detained. An opposition rally in Shia areas was met by force and a senior opposition politician was arrested and is under interrogation, although yet to be charged. Political uncertainty will remain a drag on growth, notably on private investment, for the foreseeable future.

But slower expansion in 2014-16

We expect growth to slow to an average of 3.5% pa in 2014-16, held back by:

* Declining oil output - oil production is expected to level out soon and then start to fall unless Saudi Arabia offers more of the shared oilfield output.

* Political instability - negotiations so far have made little progress, with the ruling family firmly in control and proposing only limited reform. Political unrest continues to damage Bahrain's reputation and weaken its position as a regional finance, business, logistics and tourism centre compared with Dubai, Abu Dhabi, Riyadh and Doha.

* Insufficient reform - plans to reform the labour market, reduce dependence on government and diversify the economy have also stalled. The fiscal break-even oil price is rising and close to critical levels (a factor behind the decision by Moody's in September to downgrade Bahrain's credit rating by one notch to Baa2, with a negative outlook).

Inflation up, though not a concern...

We do not expect inflation to be a constraint on growth, so monetary policy and liquidity conditions will continue to be supportive. Consumer prices fell by 0.1% in November, with annual inflation down to 3.6% from October's 15-month high of 3.8%. While food costs rose 0.2% on the month, they were offset by modest price falls for transport and miscellaneous items. Our inflation forecast remains at 2.8% in 2014 after an estimated 3.3% in 2013. A lower gold price and only gently rising world food prices will be dampening factors, and an absence of structural problems in the housing market will also contain inflation. But fuel subsidy cuts are a risk factor.

...but oil prices and politics are risks

* A large fall in world oil prices - would trigger a sharp rise in the budget deficit as Bahrain has by far the highest break-even oil price in the GCC. Public sector debt, already equal to some 35% of GDP, is rising as growth prospects remain modest.

* Political and social instability - a sharp increase in inflation or geopolitical risk could spark renewed and possibly serious social unrest. In addition, any attempt to clamp down on the opposition, coupled with a failure to move ahead with reconciliation talks, could lead to heightened political instability.

Background

One of the smallest Arab states in terms of population, Bahrain is a group of small islands in the Gulf, the main island being connected to Saudi Arabia by the King Fahd causeway opened in 1986. Since coming to power in 1999 in succession to his father, Sheikh Hamad bin Isa AI Khalifa has pushed ahead with economic and political reforms and has worked to improve relations with the local Shi'a community. Bahrain is ruled by Sunni Muslims but has a Shi'ite majority and sectarian tensions have periodically cast a shadow over local politics. In February 2001, voters approved a referendum on the National Action Charter-the centrepiece of Hamad's political liberalisation programme - and in February 2002, Hamad pronounced Bahrain a constitutional monarchy and changed his status from emir to king. Women were given the right to vote and elections have been held to choose members of the lower house of the reconstituted bicameral legislature, the National Assembly. The political turmoil, that began in February 2011 and was triggered by the political upheaval spreading throughout much of the MENA region, has not been satisfactorily resolved. There remains a danger of serious sectarian conflict unless meaningful reform occurs.

Bahrain was the first Gulf state to discover oil back in the 1930s and it experienced rapid development in the 1970s and early 1980s on the back of its oil revenues. But its oil reserves are low compared to other Gulf countries - domestic oil production, all from the Awali field, has fallen to 35,000 b/d and its reserves are expected to last only 10-15 years, though further exploration could extend this. The bulk of the country's oil wealth comes from Saudi Arabia's Abu Saafa field, with the proceeds of some 150,000 b/d given to Bahrain to help support its economy. In addition, the Bahrain National Gas Company operates a gas liquefaction plant that utilises gas piped directly from the country's oilfield, and gas reserves should last about 50 years at present rates of consumption. Petroleum and natural gas production accounted for 24% of GDP at current prices and 53% of export revenues in 2010.

Because of its limited oil reserves, the government has tried to diversify the economy, expanding into banking, heavy industry (including the world's largest aluminium smelter), retail business and tourism. When Lebanon was badly hit by its long civil war, Bahrain took over as the main banking hub for the Middle East and a centre for Islamic finance, but it has faced increasing competition from Dubai, Riyadh and Qatar for the role of leading regional financial hub. With its highly developed communication and transport facilities, it is also home to numerous multinational firms with operations in the Gulf. The international airport is one of the busiest in the Gulf, serving 22 carriers, while the modern busy port offers direct and frequent cargo shipping connections to the US, Europe and the Far East, and there is also a major shipbuilding and repair yard. And in 2005, Bahrain secured a free-trade agreement (FTA) with the US, the first such deal between the US and a Gulf state, which over time may help to expand bilateral trade flows and investment inflows.

In contrast to the contracting oil and gas sector, the financial sector now accounts for some 25% of GDP and manufacturing for over 16%, both having expanded rapidly over the years. But notwithstanding the progress and diversification over the past 20 years, and the freest and fastest-growing economy in the Middle East over that period, there are still some structural problems facing the government, most notably the level of unemployment, especially among the young, and the depletion of underground water resources.

The pace of economic growth has been rapid over the last 20 years, but has fluctuated according to changes in world oil prices. GDP growth slowed somewhat in the late-1990s and early-2000s reflecting the drop in oil prices at that time, but picked up again to average 7.3% in 2005-08 before the global crisis. Inflation has been very low, and was negative in the early 2000s before edging back into positive territory at 2% in 2006 and 3-3.5% in 2007-09 but then slowed to 2% in 2010 and -0.4% in 2011. Despite the strong growth of imports associated with efforts to diversify the economy, the strength of oil exports has kept the trade and current accounts generally in surplus.

Bahrain is a member of the Gulf Cooperation Council (GCC), which is focused on the development of common policies covering trade, investment, banking and finance, transportation and telecommunications. The Bahraini dinar (BHD) has been pegged to the US$ at US$2.66 = BHD1 since 1980.

Source: Copyright Oxford Economics Ltd. Jan 6, 2014
 Bahrain