Bahrain Economic/Political Outlook

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POLITICAL STABILITY: The Economist Intelligence Unit expects that Bahrain will experience persistent political unrest in the forecast period. The ruling Al Khalifa family faces a significant threat to its authority, and the response of the king, Hamad bin Isa al-Khalifa, will determine Bahrain’s political landscape over the next five years. There were large protests early in 2011 inspired by events in Egypt, Tunisia and elsewhere in the Arab world, calling for political and social reform. The security services used force to disperse the protesters, resulting in several deaths. Tensions rose further after the arrival of more than 1,000 troops of the Peninsula Shield Force–the combined military force of the Gulf Co-operation Council (GCC)–which many Bahrainis view as a Saudi occupation force sent to crack down on opposition groups. The government will continue to repress violently any mass protests calling for political reform and detain outspoken opposition activists.

ELECTION WATCH: The last general election for the Chamber of Deputies (the lower house of parliament) was held in October 2010. Al-Wefaq emerged as the largest group in parliament, although it fell short of a majority, winning 18 of the 40 seats. Pro-government independents won 17 seats. All of al-Wefaq’s MPs have since withdrawn from parliament in protest over the violence used against demonstrators. A by-election to replace the al-Wefaq MPs has been scheduled for September 24th, which we expect to result in a more politically homogenous parliament. The next parliamentary election is scheduled for 2014.

INTERNATIONAL RELATIONS: The US will remain a key international ally, and the US Navy’s Fifth Fleet is doubling the area of its onshore facilities in Bahrain. The US will be keen to maintain its alliance with Bahrain, as the presence of its naval base is used as a deterrent against assertive Iranian foreign policy; consideration of this relationship has been behind the subdued US criticism of the Bahraini government’s crackdown. Good relations with European partners such as France and the UK are also a priority, although these will be harmed if the government continues its use of repressive tactics to put down internal dissent. The main foreign policy concern will be Iran’s nuclear programme. Iran’s recent public statements condemning the use of force against protesters in Bahrain, and Bahrain’s subsequent summoning of the Iranian ambassador, will strain the relationship between the two countries. The government will continue to maintain publicly that it harbours no ill will towards the Islamic Republic, but the credibility of this stance has been undermined by the release of US diplomatic cables by WikiLeaks, a whistle-blowing website, quoting King Hamad as calling for decisive action to prevent Iran from developing nuclear weapons.

POLICY TRENDS: Economic policy in the short term will be focused on restoring confidence in Bahrain’s economy. The risk of political unrest will weaken foreign investment and tourism and may prompt financial institutions to seek to shift operations to other regional centres, such as Dubai or Doha, the Qatari capital. Throughout the forecast period, Bahrain will try to diversify the economy away from oil, stimulate private-sector growth and foreign investment, and address unemployment among nationals. “Bahrainisation” quotas for employing nationals have not solved the unemployment problem, and the government is therefore pursuing other initiatives, including a 1% levy on salaries to fund an unemployment insurance scheme and a levy on employers for each expatriate they employ, which finances training for nationals. (The levy on employers has been suspended because of the political unrest in a bid to support the private sector.) Since 2009 expatriate workers have had greater legal freedom to change jobs, which should slowly contribute to narrowing the cost gap between them and nationals, although there are questions about implementation.

ECONOMIC GROWTH: We have lowered our forecast for Bahrain’s real GDP growth this year to 1.8%. The political and social unrest has damaged Bahrain’s service oriented economy, resulting in two quarters of weak year-on-year growth. In the second quarter of 2011, the financial sector grew by 1.7%, while the hotels sector shrank by nearly 30%. GDP growth will average 3.7% a year in 2011-15. Bahrain’s financial sector, the cornerstone of the country’s diversification strategy, will suffer as a result of the recent unrest, which will take a toll on Bahrain’s long-cultivated “business-friendly” image. The services sector will shrink this year, harming the country’s growth prospects. However, we expect hydrocarbons to continue to be a major contributor to growth, and efforts to move hydrocarbons exports up the value chain (through higher-value-added refining, for example) will secure the importance of oil, despite the country’s low reserves. The ongoing political instability will be damaging to the country’s tourism industry, particularly tourism associated with events such as the Formula One Grand Prix, which has been cancelled this year (although it is expected to return next year). The government increased spending on subsidies and housebuilding in 2011, but we expect private financing to supplement public investment later in the forecast period.

INFLATION: Inflation will be low in 2011 as prices have weakened since the beginning of unrest. As of July prices were down by 1.3% year on year. We now expect inflation to average 0.3% for the year, much lower than levels recorded in 2010. The government has introduced a one-off grant of BD1,000 (US$2,660) for each Bahraini family in 2011 to lessen the impact of increased commodity prices, which will add to Bahrain’s already costly subsidy bill. Continued low interest rates will push inflation up in 2012, but a likely interest-rate rise in 2013 will moderate the pace of price increases. The official consumer price index is widely believed to understate price pressures. Proposals to change the subsidy system would probably cause public anger, and as a result inflation will remain artificially low.

EXCHANGE RATES: Bahrain intends to enter into a currency union with Kuwait, Qatar and Saudi Arabia, and a first meeting of a joint monetary council was held in the first quarter of 2010. The introduction of a single currency is likely to be delayed, as the member states pursue convergence on inflation and seek a consensus on the functions of the planned central bank. Initially, the single Gulf currency will probably be pegged to the US dollar, but this arrangement could be reviewed at a later stage. It is likely that the currency will eventually be pegged to a basket of currencies to give the joint central bank more leeway to alter interest rates. Meanwhile, the Central Bank of Bahrain will maintain the Bahraini dinar’s peg to the dollar at the rate of BD0.376:US$1, which has been in place for over two decades.

EXTERNAL SECTOR : The current account will record small surpluses over most of the forecast period, as oil prices buoy the trade balance and Bahrain’s services sector, which appears to have hit its low during the unrest in early 2011, recovers modestly. Bahrain relies on adding value to raw material imports and on exporting refined hydrocarbons products and aluminium. Oil prices will remain high in 2011 because of renewed growth in demand for hydrocarbons, which will support the current account, but because Bahrain imports crude from Saudi Arabia (oil imports account for roughly half of the import bill), higher prices do not necessarily improve the trade balance. We now expect the current account to register an average surplus of 3.1% of GDP over the forecast period. The income account will remain in deficit, as profit repatriation and debt interest payments outweigh dividends from foreign assets.