KEY RATING DRIVERS
The downgrade reflects the following key rating drivers:
The government has yet to identify a clear medium-term strategy to tackle high deficits and there is no clarity on a timeline towards the development of such a strategy. The government has continued to implement a number of measures to raise revenue and trim spending, including excise taxes at end-2017 and fuel price increases in January 2018. However, the consolidation effort is not close to stabilising government debt/GDP, which increased to 81.5% in 2017 from 73.3% in 2016 and from less than 40% in 2012. We project government debt/GDP to rise above 100% in the medium term. The fiscal break-even oil price remains close to USD100/barrel, according to Fitch's estimates.
The political environment, embedded social expectations and a lack of experience with taxation severely constrain the government from enacting a sharper fiscal adjustment and create uncertainty around the fiscal outlook. The gradualist approach to deficit reduction and lack of a medium-term fiscal strategy partly reflect the difficulty of building consensus over the pressing need for fiscal consolidation. Reining in the deficit more sharply could call for deeper reforms to Bahrain's social and economic model, traditionally characterised by low taxation and generous benefits. In Fitch's view, the country's leadership is generally committed to reform, but this commitment is not yet shared by other key stakeholders, and the government remains wary of social pressures.
The preliminary 2017 budget deficit narrowed to 11.6% of GDP (including extra-budgetary spending, estimated at 2.6% of GDP in 2017), from 16.0% of GDP in 2016. Higher oil prices, with average Brent crude prices up to USD55/b from USD45/b, accounted for half of the deficit reduction. Non-oil revenue increased more than budgeted and accounted for a quarter of the deficit reduction, while a decline in overall spending accounted for another quarter. Expenditure declined across most spending lines, but rising interest costs eroded just over half of the savings on primary spending. Interest costs rose to 21.5% of revenue, three times bigger than the ratio in 2014 and double the 'BB' peer median.
We forecast that the budget deficit will narrow close to 9% of GDP in 2019, still more than double the projected 'BB' median, assuming average Brent crude oil prices of USD52.5/b in 2018 and USD55/b in 2019. Oil prices would need to improve to around USD70-75/b on average to reduce the deficit to levels that would stabilise government debt/GDP in 2018-2019. Non-oil revenue will increase by 1% of GDP, assuming implementation of VAT in mid-2019 after the new parliament is in place following elections late this year. Further incremental reforms will reduce the drag on net oil revenue from subsidised fuel and gas sales. The wage bill and subsidy and transfer spending combined will decline by more than 2% of GDP, but rising interest costs will erode almost half of those spending gains. We forecast that Bahrain's fiscal break-even oil price will be around USD95/b in 2019.
We expect the consolidated gross general government debt ratio to surpass 90% of GDP in 2019 and to keep rising in the following years, albeit with a shallower upward trajectory, breaking 100% of GDP in 2023. Debt as a percentage of government revenue is expected to rise to 540% in 2019, one of the highest among Fitch-rated sovereigns. The government has started work on setting up a separate debt directorate, but has yet to agree on a medium-term fiscal framework.
Bahrain's 'BB-' ratings also reflect the following key rating drivers:
Bahrain's ratings are supported by high GDP per capita and human development indicators relative even to the 'BBB' median, a developed financial sector and the boost to external financing flexibility from strong GCC support.
Fitch estimates real GDP growth of 3.3% in 2017 and forecasts growth of 3.1% in 2018-2019, with risks to the upside. This reflects constant hydrocarbon volumes (after a decline in 2017) and a moderation of real non-hydrocarbon growth to 3.8% from an estimated 4.5% in 2017. Spending on projects financed by the USD7.5 billion (20% of GDP) GCC Development Fund provides the most significant support to growth amid government retrenchment. Growth is also supported by state-owned enterprise projects (in oil, gas, and aluminium).
The GCC Development Fund reflects the broader support that Bahrain enjoys from some GCC countries, particularly Saudi Arabia and Kuwait. This support is rooted in deep historical, cultural and familial ties as well as regional rivalries. Bahrain gets most of its oil from the Abu Sa'afa field shared with Saudi Arabia (it is entitled to 50% of production, but has sometimes received significantly more as a form of support). In Fitch's view, further material support from the GCC would be forthcoming in case of extreme political, financial, or fiscal instability, given Bahrain's small size and strategic importance. The expectation of such support has supported Bahrain's market access and US dollar peg despite extremely low foreign exchange reserves, which fell to an estimated one month of current external payments at end-2017.
Over time the government could attempt to monetise state assets, notably parts of Mumtalakat Holding Company, for some financing. Mumtalakat has a portfolio of assets with a balance sheet value of around 30% of GDP. The government is not currently pursuing asset sales, but a Mumtalakat dividend was included in the 2017-18 budget for the first time.
Political fault lines, both domestic and regional, will continue to be a source of tension in Bahrain. Lack of reconciliation between the government and the predominantly Shia opposition generates sporadic incidents of violence. The two main opposition groups have been banned and the hard-line stance against some opposition individuals and Shiite leaders has continued. The apparent sabotage of an oil pipeline in November highlighted the additional risk of terrorism. However, the seventh anniversary of the 2011 uprisings passed without much incident in February and Fitch's baseline assumption is that Bahrain's security forces will continue to prevent the sort of escalation of domestic tensions that would materially affect economic stability.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Bahrain a score equivalent to a rating of 'BB+' on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
- External Finances: +1 notch, to reflect the boost to external financing flexibility from strong GCC support.
- Public Finances: -2 notches, to reflect the high and rising debt trajectory, which we do not project to stabilise in the medium term, and the rigidity of government revenue and expenditure.
- Structural Features: -1 notch, to reflect the political and social constraints on fiscal policy, which prevent the government from cutting expenditure more rapidly and make it harder to use GDP per capita for generating more substantial diversified revenue.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The main factors that could lead to negative rating action are:
-Further significant deterioration of debt dynamics, combined with increased financing constraints.
- Severe deterioration of the domestic security environment.
The main factors that could lead to positive rating action are:
- A narrowing of the budget deficit consistent with the government debt-to-GDP ratio reaching a peak in the medium term.
- A broadly accepted political solution to domestic political tensions.
- Brent crude will average USD52.5/bbl in 2018 and USD55/bbl in 2019.
- No change to the rule of the royal family.
- Regional conflicts will not directly impact Bahrain or its ability to trade.
- No change to the peg of the Bahraini dinar to the US dollar.
The full list of rating actions is as follows:
Long-Term Foreign-Currency IDR downgraded to 'BB-' from 'BB+'; Outlook Stable
Long-Term Local-Currency IDR downgraded to 'BB-' from 'BB+'; Outlook Stable
Short-Term Foreign-Currency IDR affirmed at 'B'
Short-Term Local-Currency IDR affirmed at 'B'
Country Ceiling downgraded to 'BBB-'from 'BBB+'
Issue ratings on long-term senior unsecured foreign-currency bonds downgraded to 'BB-' from 'BB+'
Issue ratings on long-term senior unsecured local-currency bonds downgraded to 'BB-' from 'BB+'
Issue ratings on short-term senior unsecured local-currency bonds affirmed at 'B'
Issue ratings on the sukuk trust certificates issued by CBB International Sukuk Company 5 and 6 have been downgraded to 'BB-' from 'BB+'
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Country Ceilings Criteria (pub. 21 Jul 2017)
Sovereign Rating Criteria (pub. 21 Jul 2017)
Sukuk Rating Criteria (pub. 14 Aug 2017)
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