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Mar 24 2006

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Bahrain: Country outlook

OVERVIEW: The Economist Intelligence Unit expects tensions between the ruling Sunni minority and the less affluent elements of Bahraini society, mostly made up of the Shia majority, to continue in 2006-07. The opposition coalition that boycotted the 2002 parliamentary election seems determined to pursue its demand that the king, Hamad bin Isa al-Khalifa, repeal constitutional changes that in effect give him a built-in majority in parliament. It appears likely, however, that key opposition groups will contest the forthcoming election, pursuing their grievances from within parliament. Given this, the king may be prepared to make some concessions, but he is unlikely to back down on this core issue, and the outcome of the current impasse still lies very much in the balance. The government will continue to push to diversify the economy away from its dependence on oil and pursue other structural reforms to tackle the country’s unemployment problems. Bahrain’s fiscal and current accounts will remain in surplus in 2006-07, although both surpluses will contract as the forecast period progresses.

Domestic politics: Long-standing tensions between the ruling Sunni minority and the less wealthy elements of Bahraini society, mostly made up of the majority Shia population, will persist throughout the forecast period. The October 2002 parliamentary election, Bahrain’s first in three decades, failed to achieve the difficult task of eliciting widespread endorsement of a political system that, despite some liberalisation, is still dominated by the ruling Al Khalifa family. Although we do not expect a return to the levels of civil unrest witnessed in the mid-1990s, political tension appears to be rising (recently there have been public demonstrations over perceived inequities in the constitution), and sporadic incidents of violence stemming from such protests could occur. Furthermore, the newly enacted Political Societies Law, which seeks to curb the activity of political associations through, among other limitations, restricting their membership and sources of funding, has already caused splits in the opposition, radicalising elements within it. Coupled with a draft family law, against which the Shia ulema (clerics) look to be mobilising, political tensions look set to rise in the coming months, particularly in the run-up to the next legislative election, provisionally scheduled for October 2006.

International relations: Bahrain’s foreign policy has been dominated by the need to maintain strong relations with the region’s larger and wealthier powers, namely Kuwait, the UAE and Saudi Arabia, which are its main financial backers. However, Bahrain’s increasingly close ties with the US appear to have begun to irritate Saudi Arabia, the pre-eminent power in the region and the dominant force within the Gulf Co-operation Council (GCC). Bahrain has long hosted the US Fifth Fleet, but the US sought to strengthen military ties in October 2001 by designating it a “major non-NATO ally”. Ties have also been strengthened in the economic sphere, with the rapid conclusion in December 2005 of a bilateral free-trade agreement. Saudi Arabia has objected to the accord, arguing that it contravenes Bahrain’s commitments under GCC trade agreements, and Saudi disapproval may have contributed to an apparent decision by Riyadh to reduce its financial support for Bahrain in the form of crude oil transfers. There is little risk of relations with Saudi Arabia deteriorating further, however, with the Saudi administration having already exhausted much of its economic leverage over Bahrain, and given Saudi Arabia’s ultimate interest in maintaining stability in the island kingdom.

Policy trends: Bahrain’s economic outlook appears less robust after Saudi Arabia’s decision to reduce its oil-related support, although high oil prices will mask the impact in the short to medium term. Transfers of crude oil from Saudi Arabia to Bahrain fell by about 50,000 barrels/day (b/d) in the third quarter of 2004, and it would appear that this additional source of support is no longer on offer. The impact of the reduction on Bahrain’s fiscal position (amounting to more than 20% of oil receipts, local output included) has been mitigated by high oil prices and is therefore not expected to restrain government consumption significantly over the forecast period. Besides this, Bahrain has not received any additional revenue from the doubling of capacity, to 300,000 b/d, at the Abu Saafa oilfield, which it shares with Saudi Arabia but which is administered by the Saudi oil monopoly, Aramco. (Since the mid-1990s Bahrain had received all of the revenue from the field.) It is over a year since the expansion at Abu Saafa came on stream and we now assume that Bahrain will not receive any increases in oil transfers from Saudi Arabia in the near future. However, it remains likely that its bigger neighbour would lend Bahrain financial assistance should it suffer a prolonged economic downturn.

International assumptions: After several years of strong expansion, the global economy is likely to be characterised by a gradual deceleration in output and demand growth over the forecast period, driven in particular by more sluggish economic activity in the key economies of the US and Japan. We expect world GDP growth (on a purchasing power parity basis) to slow to 4.3% in 2006 and to 4.1% 2007, down from 4.6% in 2005.

Economic growth: With oil prices set to remain historically high, the government will be given the leeway to continue its attempts to address social concerns. It will thus maintain trend levels of growth in public expenditure, although, more broadly, domestic demand may ease on the back of higher interest rates. Economic growth will also be buoyed by an expansion at Alba, the country’s largest industrial concern, which will raise domestic production and lift exports. Growth will be underpinned by continued high levels of construction activity, as work on large-scale projects such as the BFH continues. The government is also expected to press ahead with the liberalisation of utilities, which should promote more rapid inflows of foreign investment. In mid-2004 the authorities awarded the contract for the establishment of Bahrain’s first independent power project, which is due to come on stream by mid-2006. A US$1.3bn integrated petrochemicals, power and water complex is also planned by Kuwait Finance House. Expansion work at the refinery of the state-owned Bahrain Petroleum Company (Bapco) should be completed in 2007, and services exports will be supported as a major port development at Hidd opens. However, import volumes will remain high in order to feed these projects and will serve to restrain the impact of consumption and investment on overall growth. Consequently, real GDP growth is forecast to ease to 5.6% in 2006, before slipping further to 5.3% in 2007.

Inflation: Inflation is expected to average 2.5% in 2006, down slightly from an estimated 2.7% in 2005, as a decline in average prices for international non-oil commodities weakens import prices, and as growth in domestic demand is curbed by rising interest rates. These trends will continue into 2007, although a less marked rise in interest rates will curtail any further drop in domestic demand. Given an additional decline in import prices, we forecast that the average rate of inflation will ease again slightly to 2.4%.

Exchange rates: The Bahrain Monetary Agency (the central bank) will maintain the Bahraini dinar’s peg to the US dollar, in place since 1981, at the rate of BD0.376:US$1. At the end of February 2005 (the most recent data available) foreign reserves stood at US$1.85bn. Although providing only around 3.2 months of import cover, reserves are largely in line with historical levels. It is highly likely that Bahrain would be able to rely on support from its wealthier neighbours in the event of a crisis.

External sector: We expect export earnings to strengthen in 2006, with oil receipts projected to pick up by around 12%. Non-oil exports will also strengthen as Alba enjoys its first full year of expanded output after the commissioning of its fifth potline, supporting a rise in overall export values of 18% to US$11.9bn. Imports are also expected to increase, although the rate of growth will be slower than in 2005, as expansion in spending on capital goods for use in large-scale, state-backed projects slows, with some of them coming to completion. As a result, the trade surplus will expand slightly in 2006 to US$3.4bn. Oil prices will drop in 2007, by some 8%, causing a 4% fall in overall export revenue, with the rate of contraction slowed by further gains in non-oil exports. Import values will continue to rise, by around 2%, in 2007, as the cost of Bahrain’s imported oil remains high. These flows will cause a more marked narrowing of the trade surplus, which will close the forecast period at US$2.8bn, although this still remains large by historical standards, reflecting persistently high oil prices.