28 March, 2016

Dealing with downgrades

While the Bahraini asset management sector has remained stable, the local market and economy has faced a number of challenges.

Home to a growing Islamic banking sector and a healthy asset management community, MenaFM takes a closer look at the latest developments in Bahrain
With one of the oldest established mutual fund industries in the region, the Bahraini asset management sector has continued to thrive in recent years. Capital Manama has also seen the growth of the Islamic banking sector in recent years and remains one of the region's key centres for financial services. Its reputation in the Gulf has been built with longheld plans to attract firms to its shores and help develop the industry.

Bahrain is home to dozens of asset managers, including some of the best-known asset management names in the region, such as alternatives giant Investcorp and financial services group SICO.

Having opened up to firms from all around the world over the years, Bahrain today hosts a significant number of the biggest international and regional asset management firms and banks.

It is also a major domicile for funds in the region. As of 31 August 2015, there were 2,879 mutual funds - up from 2,852 at the end of 2014 - with a net asset value of more than $7bn, according to official figures.

Yet, while the Bahraini asset management sector has remained stable, the local market and economy has faced a number of challenges more recently.

Sovereign downgrade

The low oil price environment has continued to affect economies across the region and Bahrain has not been immune to challenging market conditions. The S&P Bahrain BMI Index contracted by -8.1% during 2015; although it fared better than some regional peers, losses followed an 8.7% rise in 2014 and a 42.2% gain in 2013.

Economic growth has slowed also. The IMF reported that GDP was likely to have hit 3.2% during 2015 compared with a 4.5% rise in 2014. Real GDP growth is likely to hit 2.8% in 2016, claimed the IMF representative Padamja Khandelwal, following a visit to Manama earlier this year.

Although Bahrain remains less dependent on its hydrocarbon sector than its GCC neighbours, the fall in oil price has taken a toll. Its breakeven price of more than $100 per barrel is high compared with the low price of oil currently. However, production of 200,000 barrels per day amounts to less than 1% of the region's total daily production of 25 million barrels per day and less than 3% of its natural gas output, according to IMF figures.

As a more diversified economy than its regional peers, the decision by Standard & Poor's to cut Bahrain's sovereign credit ratings by two notches came as a shock, particularly as it prepared a $750m bond sale.

"Since 2014, when oil prices started to slide, pressure on revenues has become particularly acute in Bahrain, and we think the impact of this lasting trend will exacerbate existing structural frailty in Bahrain's public finances, despite an active response from authorities," the rating agency noted.

Speaking at the GCC Financial Forum in February, Central Bank of Bahrain (CBB) governor Rasheed Mohammed Al Maraj said it had been very disappointed by the rating agency's decision to downgrade it to 'BB' status.

While the central bank later made a smaller $200m bond issuance, the action by Standard & Poor's rankled. Al Maraj said in the lead-up to the downgrade the bank had made aggressive action to resolve some of the concerns over the Bahraini budget, including the removal of some subsidies.

"The whole thing was unfortunate and it does not make our relationship with them comfortable," said Al Maraj. "This is an opportunity for us to refresh our economy and move forward. We have been more or less shamed by this umbrella of subsidies that has really held back the potential of our economy.

"Not only in terms of the cost structure of doing business but also in the social mindset of people and addressing their prospects for jobs.

"We will not be able to move forward if we remain hostage to this mentality of government subsidies and [a] government role in our lives."

Khalid Al Rumaihi, chief executive of the Bahrain Economic Development Board (EDB), says Standard & Poor's had "erred on the side of overeagerness" in making the cut. The non-oil sector grew by 4% during 2015, says Al Rumaihi, while there are also a number of infrastructure projects in the pipeline.

"The global economy seems to be looking for a sense of direction," adds Jarmo Kotilaine, chief economist and executive director of strategy and planning at the EDB, highlighting questions over the slowing Chinese economy and the need for central bank action.

"My personal view is that a change in direction will come primarily from the central banks," states Kotilaine.

The economist says the situation in the region is more reflective of the oil price volatility and the government response to low prices.

"What we are looking at is a fiscal rearranging process that will redefine the role of government [in the region]," he adds.

Standard & Poor's was not the only rating agency to remain unconvinced by the longer-term outlook, however, as rival Moody's Investors Service also took action, cutting its sovereign rating by one notch to junk status with a negative outlook.

Financial services in Bahrain Contributing 17% of its GDP, financial services is an extremely important sector for the Bahraini economy and one of its key drivers of growth.

The EDB's Al Rumaihi highlights the low operating costs in comparison with the region's other financial hubs as well as the strength in human capital, noting the 14,500 people employed within the Bahraini banking sector alone.

There are also other sectors within the financial services industry where Bahrain can develop, says Al Rumaihi, citing ancillary services, such as middle- and back-office functions, as an example.

"The GCC used to be a market that financial institutions didn't think about expanding operations particularly through the middle office and back office," he says.

"Banks used to purely have just a front office here. But now [they've] become a significant size, they have to think about having that middle and back office component."

Further developments are planned on the asset and wealth management front. On the asset management front, new legislation is under way to establish a trust structure.

"Bahrain is considering a trust law, that we hope will pass this year," says Al Rumaihi. "It will be a 'game changer' in that it will allow Gulf nationals to register their Gulf assets in Bahrain and offer the same services in a trust as you would find in Jersey or other jurisdictions."

The CBB has been seeking views on the implementation of the new trust legislation, which closed on 16 March.

Khalid Hamad, executive director at the CBB, says although the new structure must first be approved by the Bahraini parliament, it would "add value" to the asset management sector and help facilitate the setting up of cell companies, which are not common in the region.

As well as the new trust structure, there have been other developments within Bahrain's asset management sector. The Bahrain Bourse announced that it is preparing to list its first such vehicles later in the year.

It is the latest innovation for the Bahraini exchange which, earlier this year, announced the launch of a US treasury bills market aimed at supporting and enhancing its capital markets sector. In March the Bahrain Bourse had listed 10 issues in the new market worth a total of BHD542m ($1.4bn) issued by the CBB.

As Bahrain has been impacted by the same macroeconomic headwinds affecting other GCC economies, so too have the region's stock markets. Lower oil prices have impacted liquidity across the region and dented investor risk appetite. The weaker economic environment has seen few new companies listing on the region's markets. Bahrain has not been an exception to this trend, explains Kotilaine.

"Over several years, there have been limited primary listings in the GCC and very little outside of Saudi Arabia," says the EDB economist. "It's been a challenging environment across the region. In Bahrain there have been a couple of primary listings [over the years].

"What's happening now is a more structured effort to develop the stock market, in terms of liquidity. There are several initiatives that are designed to encourage more companies to come to market."

Developing Islamic finance As well as the conventional financial sector, Bahraini authorities have underlined their eagerness to maintain its position as one of the region's leading Islamic banking sectors.

Global consultancy EY highlighted the growth of Bahrain's Islamic banking sector in its recently published World Islamic Banking Competitiveness Report 2016. Banking assets are expected to increase by $1bn by 2020 to $16bn, noting the growth of the sector in recent years.

While Bahrain's Islamic finance sector has continued to grow in recent years, so too has the demand for qualified staff.

Solveig Nicklos, director at the Bahrain Institute of Banking & Finance, a training institution, says its strong human capital resources have made Bahrain an attractive proposition for many local and regional financial institutions. She says Islamic finance has been one of the fastest growing areas for training, prompting the development of new programmes and qualifications.

"Our institution had one of the first programmes in this area," she says. "We're seeing increased demand in a number of areas [of Islamic finance]."

Nicklos notes the institute offers a number of professional and academic qualifications in Islamic finance, as well as a range of standard offerings in partnership with other educational and professional bodies.

Bahrain has also strengthened the regulation of the Islamic finance sector, says the CBB's Hamad. He says the recent introduction of a centralised Sharia board structure by the central bank allows the regulator to concentrate on developing compliant products and banks to focus on investment decisions.

The introduction of a Sharia board by the CBB has allowed it to set standards across the banking industry, says EDB's Al Rumaihi. While each Islamic bank will continue to have its own board, the CBB can help promote "uniformity" across the sector, he adds.

Downgrade impact

While Bahrain was not alone among the region's economies in facing action by ratings agencies, its downgrades were perhaps unexpected. The government had already begun enacting measures to tackle concerns over its sovereign ratings, which has been taken into consideration by the agencies. However, of greater concern may be the outlook for the Bahraini economy.

Although Standard & Poor's was the larger cut, it retained a stable outlook for the economy. Rival Moody's was more cautious, however, questioning authorities' plans to react to the low oil price environment. (The remaining of the 'Big Three' rating agencies Fitch affirmed its rating, while downgrading its outlook towards the end of 2015.)

"Moody's decision to place Bahrain's rating on review for further downgrade reflects the uncertainty over the pace and effectiveness of the government's policy response to contain the negative impact of lower oil prices," it noted.

One of the biggest implications for the Bahraini economy of the downgrades has been for the financial sector. The CBB's Al Maraj warned that downgrades could have an impact on the financial services sector, affecting banks in particular.

In its downgrade note, Standard & Poor's noted that while the Central Bank of Bahrain was not expected to act as a lender of last resort to offshore banks, it did consider that Bahraini government was a potential source of support for wholesale institutions not covered by parent entities or home countries.

However, regulators point out that Bahrain has one of the robust banking regulatory regimes in the region, having come through the financial crisis relatively unscathed.

The further diversification of the economy and the pipeline of infrastructure projects are underlined by Bahraini officials as positive drivers for growth in the near future.

With oil prices having seemingly bottomed, there may be more optimism in store for the future of the Bahraini economy. Yet, after the sovereign downgrades earlier in the year, it remains to be seen whether international investors will be willing to risk their cash.

© MENA Fund Manager 2016

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