Moody's downgrades Bahrain's ratings to B2

SINGAPORE — Moody's Investors Service has downgraded on Friday the government of Bahrain's long-term issuer ratings to B2 from B1 and maintained the negative outlook.

The key driver for the rating downgrade is a further rise in Bahrain's external and government liquidity risks to particularly elevated levels, constraining access to market financing to a greater extent than Moody's previously envisaged. Despite higher oil prices over the past year, the government's gross borrowing needs remain very high and foreign exchange reserves very low. Meanwhile, heightened external and government liquidity pressures have not prompted the authorities to accelerate the implementation of fiscal reforms, which Moody's expects to remain very slow.

The B2 rating assumes that Bahrain's Gulf Cooperation Council (GCC) neighbors will provide some financial support, consistent with a broad statement issued on 27 June and without which Bahrain's creditworthiness would be significantly weaker.

The negative outlook reflects the risk that financial support from the GCC is not timely and comprehensive enough to maintain Bahrain's credit profile at B2 through a series of forthcoming debt repayments, including a $750 million sovereign sukuk repayment due on 22 November 2018.

Moody's has today also lowered Bahrain's long-term foreign-currency bond ceiling to Ba3 from Ba2 and long-term foreign-currency deposit ceiling to B3 from B2. The short-term foreign-currency bond and deposits ceiling remain unchanged at Not Prime. Bahrain's long-term local currency country risk ceilings were lowered to Ba2 from Ba1.

In addition, the long-term foreign-currency bond and deposit ceilings for Bahrain - Off Shore Banking Center were lowered to Baa2 from Baa1, while the short-term foreign-currency bond and deposit ceilings remain unchanged at Prime-2.

Persistently high external financing needs for the government and the economy as a whole in the context of impaired access to the international capital markets indicate heightened external and government liquidity risks for Bahrain.

Moody's estimates that Bahrain's financing needs amount to more than 30% of GDP in 2018-20, a very high level internationally. Relatedly, Moody's continues to expect Bahrain's debt burden to rise to around 100% of GDP at the turn of the decade, from just under 90% in 2017. Assuming that

domestic debt is refinanced, the government will need to finance $2.4 billion (around 6.5% of GDP) and $3 billion (7.5% of GDP) externally in the remainder of 2018 and in 2019 respectively. These domestic and external financing needs have not been reduced materially, despite higher oil prices over the past year that have most likely materially boosted government revenue.

In contrast with proven and repeated market access in the past several years, Moody's believes that the sovereign's ability to issue in the international capital markets has become impaired. In March this year the government abandoned its plan to issue both a conventional bond and a long-dated sukuk, and instead issued a $1 billion sukuk at a 7.5-year maturity. Furthermore, in May, the investment and development arm of Bahrain's government-owned National Oil and Gas Authority (nogaholding) abandoned plans to issue $1 billion of notes. Finally, in late June Bahrain's sovereign CDS spreads spiked to above 600 basis points (bps) – a level previously only reached at the height of the global financial crisis – from 250-300bps in the first quarter of the year.

Similarly, access to external financing is critical to prevent a further erosion in already very low foreign exchange reserves. Moody's estimates that, in the absence of new external debt issuance, the drain on Bahrain's reserves will amount to around $2.5 billion this year, rising to around $3.5 and $4 billion in 2019 and 2020 respectively. This is consistent with the fact that central bank reserves rose by less than $200 million during 2017 to $2.3 billion at the end of the year, even though the government issued $3.6 billion of international bonds and sukuk - in addition to a $500 million bond that was privately placed - and had no significant external debt repayments. Reserves have since fallen to $1.8 billion in May 2018, well short of Bahrain's external financing needs.

Bahrain's B2 rating assumes that the kingdom's GCC neighbors will provide some financial support, consistent with a broad statement issued on 27 June that the Bahraini Ministry of Finance was in discussions with its GCC partners regarding various options that would support the kingdom's economic reforms and strengthen its financial stability. The GCC has in the past provided funds for some investment projects in Bahrain, as part of the GCC Development Fund, although disbursements have been slow.

In the absence of such support, Bahrain's creditworthiness would be significantly weaker as forthcoming debt payments would further deplete very thin buffers, threatening macroeconomic stability. Future debt payments include a $750 million sukuk maturing on 22 November 2018, an international bond repayment of $435 million due next May and an estimated $0.9 billion of sovereign external debt interest payments over the next 12 months.

LACK OF POLICY RESPONSE TO RISING LIQUIDITY PRESSURES UNDERSCORES LIMITED

POLICY FLEXIBILITY

In the face of these credit challenges, the government has not announced any new significant policy measures that would indicate capacity to address weak and weakening fiscal and external credit metrics.

The implementation of the value-added tax, originally planned for 2018, has been postponed until next year. Meanwhile, in January all new fiscal austerity measures were suspended until parliament agrees on a new system to compensate citizens for the higher cost of living implied by the measures. The most significant fiscal measure implemented this year is the excise tax on soft drinks and tobacco products, which is expected to yield around 0.4% of GDP in extra revenue. By comparison, the government expects the overall spending to increase by close to 1% of GDP.

Moody's believes that the lack of new policy announcements in the face of rising liquidity pressures underscores very limited policy flexibility and weaker institutional strength than previously assessed. The overall policy response to lower oil prices has been slow in previous years and appears to remain so despite the fact that the urgency of some significant fiscal adjustment has increased.

Bahrain's creditworthiness continues to be supported by high per-capita income levels, a relatively diversified economy and a net international investment position, parts of which could provide some financial buffer to meet external payments (standing at $31 billion or 87% of GDP in 2017, albeit likely to continue to decline in coming years).

Bahrain also has potential, over time, to improve its fiscal and external metrics by tapping its recent oil discovery and by taking advantage of its relatively diversified economic base to diversify fiscal revenues.

However, the degree to which this potential will be fulfilled is as yet highly uncertain. Oil production from the recently discovered large off-shore oil reservoir will likely, in the long term, improve Bahrain's fiscal and external position. However, at the current stage of exploration, Moody's cannot ascertain with any degree of confidence how much of the announced 80 billion barrels of oil-in-place could be technically recoverable and at what cost. In any case, the government does not expect oil production from the new field that would materially improve Bahrain's fiscal and external balance to start before early 2023.

Also, in the longer term, and as part of its fiscal reforms, the government could harness the country's relatively diversified economic base -- with the non-hydrocarbon sector's share of value added at more than 85% -- to increase the size of its non-oil revenues. Unlike its GCC neighbors, Bahrain currently does not impose non-oil corporate income taxes on either national or foreign-owned companies. However, the authorities have so far shown no intention to introduce significant newnon-oil revenue measures, including corporate or personal income taxes, that could diversify the government's revenue base. In 2017, 75% of all state budget revenue was derived from oil and gas production and most of the rest was due to miscellaneous fees, levies, duties and some dividends and property income transfers from the government's (mostly domestic) holdings managed by Mumtalakat and nogaholding.

The negative outlook reflects the risk that financial support from the GCC is not timely and comprehensive enough to maintain Bahrain's credit profile at B2 through the series of forthcoming debt repayments.

Despite the 27 June announcement stating that an "integrated program [] will soon be announced", there has been no further communication to date, either from the Bahraini authorities or from Saudi Arabia (A1 stable), the UAE (Aa2 stable) and Kuwait (Aa2 stable).

As a result, there is a risk that such support may not be sufficient to stabilize Bahrain's credit metrics and in particular allow the government to meet its debt obligations while avoiding prohibitively expensive costs.

Support that is limited in size, disbursed slowly and/or not accompanied by clear and credible information about the timing and modality of disbursements may not restore Bahrain's access to international financial markets. With large financing needs projected to persist, Bahrain's creditworthiness would remain highly reliant on this GCC support, but with diminished confidence about its effectiveness. Limitations on the support that is provided would also potentially raise concerns about the sustainability of the currency peg, raising the probability of a balance of payments crisis.

Given the negative outlook, an upgrade is unlikely in the near future. Moody's would likely change the outlook to stable if a detailed and credible announcement of GCC financial support was made and if such support raised the probability that the government would undertake comprehensive fiscal consolidation which would materially narrow non-oil fiscal deficits and stabilize its debt burden. Such a policy announcement would probably enable Bahrain to regain access to the international capital markets, diversifying its financing sources. Combined, the availability of GCC financial support and regained market access would provide some scope to rebuild the central bank's foreign exchange reserves.

Moody's would likely downgrade Bahrain's rating in the event of continued deterioration in fiscal and external metrics amid a prolonged absence of a detailed announcement from the GCC countries about the group's commitment to support Bahrain's government and external financing needs.

Possibly related, a downgrade would also likely occur if the sustainability of Bahrain's pegged exchange rate regime was increasingly threatened. — SG