The kingdom of Bahrain has thrived as one of the Gulf’s financial centres for decades. Despite increasing competition from emerging financial centres in the region, its advanced regulatory framework, educated workforce and relatively low-cost environment means that it remains an attractive platform for companies engaging with the wider GCC and beyond. The recent decline in oil prices, however, serves as a reminder of the government’s reliance on its hydrocarbons resources for revenues. Facing a stubborn fiscal deficit, Bahrain is in the process of overhauling its subsidy framework and seeking new income streams, both of which are challenging prospects in an economy renowned for generous social support and light-touch taxation. The kingdom’s long-standing diversification strategy, meanwhile, has taken on a new urgency with the prospect of volatile oil prices for some years to come.

THE MACRO PICTURE: Bahrain is one of the smallest economies in the GCC, with a GDP of $32.2bn in 2015, according to the World Bank, comparable in size to nations such as Bolivia, Serbia, Côte d’Ivoire and Cameroon. Its size, however, belies its significant role in the region, which is most obviously seen in the functions of its important financial sector. Thanks to its early emergence as a well-regulated centre for banking, insurance and asset management, the kingdom’s capital, Manama, was home to 404 financial institutions as of September 2016, which serve not only the relatively small domestic market but also the wider GCC and beyond.

Bahrain’s authorities have carefully nurtured this vital part of the economy as a means to reduce the kingdom’s reliance on oil extraction as a source of revenue — an objective which is lent greater urgency by the fact that Bahrain’s proved oil reserves of around 632.5m barrels represents only a small share of the Middle East’s total of 803bn barrels, as estimated by BP. The government’s efforts to date have proved fruitful; in 2015, Bahrain’s financial and banking sector represented 17.2% of GDP, according to the Central Bank of Bahrain (CBB). Government diversification efforts and a falling oil price combined to reduce the contribution of hydrocarbons activity to GDP to less than 20% in 2015, although oil production levels have shown modest growth over recent years (see Energy chapter).

Beyond the financial sector, Bahrain has successfully developed a number of other non-oil sectors, including aviation, communications, industry and real estate. One of the most salient developments within Bahrain’s increasingly diverse range of economic activity is the success of Alba, one of the world’s largest aluminium smelters, renowned for its technological advancement and high-quality product.

The non-oil sector is expected to drive economic growth over the coming two years, with the Bahrain Economic Development Board (EDB) expecting the economy to expand by 2.4% in 2017, compared to a 0.5% growth of the hydrocarbons sector.

Real GDP, meanwhile, is expected to expand by 2% in both 2017 and 2018, according to the EDB, although estimates from independent institutions vary widely and are subject to frequent revision as the outlook for oil prices changes.

FISCAL CONCERN: Despite the steady growth of Bahrain’s GDP, the kingdom has faced a challenging fiscal scenario in recent years. While non-oil activity is increasing, Bahrain’s lack of personal or corporate taxes means that revenue from hydrocarbons activity generally accounts for around 85% of the annual total. Bahrain therefore continues to rely heavily on its oil revenue to pay recurrent expenditures such as manpower, services, consumables and debt servicing. This renders Bahrain vulnerable to changes in worldwide oil demand and fluctuation in oil prices, which became fiscally problematic for the kingdom in the wake of the global economic crisis of 2008 – the last year in which it enjoyed a surplus, of 6.6%. Despite the prospect of fiscal deficits, Bahrain opted to maintain an expansionary fiscal stance over the following period, a policy decision which became more difficult to alter after the social unrest occasioned by the Arab Spring of 2011, which heightened demand for increased government support in areas such as housing, health and education.

LOWER OIL PRICES: The decline in oil prices, which began in the second half of 2014, only exacerbated this problem. Oil revenues for 2015 were reduced by around 10% of GDP, which resulted in a general fiscal deficit of 12.5% — from 3.3% in the previous year, according to the World Bank. As a consequence, by early 2016 the kingdom’s public debt had risen to 63% of GDP, which prompted the government to raise the public debt ceiling to BD10bn ($26.5bn), representing approximately 80% of GDP. Current levels of public debt exceed the GCC-agreed threshold of 60% of GDP, and the prospect of more borrowing by the sovereign has played a large part in the decision of the major rating agencies to adjust their appraisals of the kingdom’s economic outlook. For example, Standard & Poor’s downgraded Bahrain’s rating to “BBB-/A-3” in 2015 with a negative outlook, and further downgraded it in 2016 to “BB-”, but with a stable outlook. Some observers have pointed out that international ratings agencies have failed to take into account the support that Bahrain enjoys from its larger neighbour, Saudi Arabia, and other allies in the region. The most visible manifestation of this support is the Gulf Development Fund, which has assisted the kingdom in meeting its fiscal obligations.

The Islamic International Rating Agency is a Manama-based institution established in 2005 that specialises in markets where sharia-compliant finance plays a significant role. In 2016 it granted Bahrain a sovereign long-term rating of “BBB”, or adequate credit quality, and a short-term rating of “A3”, indicating satisfactory liquidity and an expectation of timely payments on instruments.

BRIDGING THE GAP: Bahrain’s central economic challenge is a structural fiscal deficit that has remained in place since 2008. The kingdom’s lack of significant wealth reserves means that it has been compelled to rely on a combination of debt issuance and regional support in order to meet its fiscal obligations. Despite the downgrade of the sovereign rating, the response to the kingdom’s public debt issuances has been positive, indicating investor confidence in the government’s ability to manage its overall debt burden, which includes development bonds, regular issuance of Treasury bills and a number of Islamic leasing securities.

Domestic banks operating in the kingdom have always shown a willingness to buy government debt, viewing it as an easy route to yields, and traditionally issuances have been secured by institutions almost on an allocation basis and held to term, with no secondary market activity at all. Recently, however, the Bahrain Bourse and the CBB have established a new system in which individual investors can gain direct, beneficial access to primary government debt issuances (see Capital Markets chapter).

The regional support that Bahrain enjoys stems from the period of social unrest in 2011, when the UAE, Kuwait, Saudi Arabia and Qatar joined forces to establish a $10bn financial development package for the country, to be paid over a ten-year period. This funding has been directed towards the kingdom’s infrastructural needs, and has allowed the country to maintain a sizeable project pipeline despite the low oil prices seen throughout 2015 and 2016.

By August 2016 the cumulative value of tendered projects stood at just over $4bn, up from $1.2bn in 2015, the vast majority of which were GCC-funded. The largest sectoral recipient of this figure was housing, which accounted for 36% of the total, followed by electricity and water (21%) and roads (12%), while the single biggest recipient was the Bahrain airport project; the initial preparatory work for which accounted for 16% of the total.

Overall, Bahrain saw an 11% year-on-year increase in the number of construction permits during the first eight months of 2016. The kingdom, therefore, has been able to utilise the Gulf Development Fund to maintain a capital spending programme that is central to the growth of the non-oil economy, while using a combination of government revenues and debt issuances to cover its recurrent costs.

CUTTING COSTS: There are limits, however, to how much public debt the country can carry before investors react negatively and further borrowing becomes prohibitively expensive. Similarly, the grants it has received from regional allies are a finite entity. The government’s focus since the oil price decline, therefore, has been on the longer-term fiscal adjustment necessary to balance its books, a task which calls for both the cutting of expenditure and the raising of revenues. As with other GCC nations, subsidies are a prime target of the government’s cost-cutting drive. Support for items such as meat, flour, gas, petrol, diesel, electricity and water accounted for 21.1% of total expenditure in 2015.

Attempts at subsidy reform, however, have been slowed by a desire to protect the population from economic discomfort during a period of muted growth. Early efforts at subsidy reduction, therefore, were restricted to the business community: industrial tariffs for gas in Bahrain were increased by 50 percent on January 1, 2012, which resulted in an annual estimated saving of 1.4% of GDP, according to the IMF. The oil price decline, however, has made subsidy cuts on items consumed by the general population a necessity. In late 2015 Bahrain removed subsidies on beef and chicken, effectively doubling their market rate, while in January 2016 it slashed support for diesel, kerosene and petrol, a move which resulted in a 60% rise in pump prices. The real prizes in the subsidy arena are those directed to electricity and water, which were the single biggest expenditure on the subsidy list in the 2015.16 budget. They are also amongst the most politically sensitive. In mid-2015 the joint government-parliamentary committee formed to discuss the question of subsidy cuts and agreed that spending on electricity and water subsidies for citizens’ homes would remain in place for 2015 and 2016. The government has therefore focused on the business sector and the expatriate population. In early 2016 the government approved cuts that will eventually see power and water prices double for expats and the industrial sector, saving the government an estimated $1.1bn.

BOOSTING REVENUE: Increasing revenue is a more challenging proposition for government planners, as the low tax environment that has helped to establish Bahrain as a regional commercial centre leaves few options for policy adjustments which might boost government income. There are no taxes at all on personal income and corporate income other than that placed on oil companies. In addition, there are no wealth, capital gains, death or inheritance levies. According to the IMF, the non-oil tax revenue of Bahrain stood at 0.6% of GDP in 2014.

Attempts to remedy this situation have, to date, been limited to increases in fees charged for government services, for example, through the imposition of a health care charge of BD72 ($190.98) per year on foreign residents’ visa fees. While the introduction of a more widespread corporate tax or a tax on personal income is unlikely in the medium term, despite consistent encouragement from the IMF, another change to the tax framework promises to provide the government with a much needed revenue boost. In February 2016 Gulf ministers finally signed off on the long-anticipated framework for a value-added tax (VAT), which will be implemented across the region from January 1, 2018. While each country is free to establish its own exemptions from the tax, the IMF estimates that the introduction of VAT in Bahrain will bring $568m to government coffers annually, assuming a 5% rate, which is equal to about 1.6% of Bahrain’s GDP (see analysis).

DIVERSIFICATION PUSH: In the longer term, however, one of the most effective solutions to Bahrain’s fiscal deficit is the creation of a more balanced economy capable of producing a wider array of exports than is currently the case. As with most governments in the region, authorities in Bahrain have been using surplus oil revenues to encourage economic diversification for decades. The government’s strategy in this regard is contained in the Economic Vision 2030 document, which has the broad aim of creating a sustainable, competitive and fair economy, capable of doubling household income by 2030.

Shorter-term development is governed by the National Development Strategy (NDS), a regularly updated action plan by which the broad ambitions of Economic Vision 2030 are implemented through the establishment of specific milestones across the entire public and private economic landscape, including education and training, fiscal matters, health and societal concerns. A range of state bodies work together to drive this agenda, the most prominent of which is the EDB, a public agency mandated to attract inward investment and enhance the general investment climate of the country. Chaired by Sheikh Salman bin Hamad Al Khalifa, the crown prince, and including representatives from both the government and private sector, since its inception in 2000 the organisation has spearheaded initiatives ranging from the provision of social housing to opening Bahrain to international ratings.

In 2005 it established the government’s investment arm, Mumtalakat, which over the past decade has developed and managed a portfolio of non-oil and gas-related assets, and maintained strategic holdings in sectors such as aluminium, real estate and aviation. Other institutions in Bahrain’s diversification effort include Tamkeen, the national labour fund responsible for enhancing the skills of Bahraini nationals, the Bahrain Development Bank, which has played a particularly important role in helping to develop a nascent small and medium-sized enterprise (SME) segment, and the CBB, which through its careful stewardship is largely responsible for Bahrain’s status as a financial hub. “Support from Tamkeen is monumental in enabling Bahrainis to develop their skills and enabling companies to hire and promote them to higher levels of the organisation,” Ricardo Langwieder-Goerner, CEO of Silah Gulf, told OBG.

TARGETED SECTORS: Together, these bodies have done much to improve the investment climate in Bahrain (see analysis). The decline in government revenues means that the kingdom’s ability to attract foreign investment is crucial to its diversification efforts, and the EDB has identified five strategic sectors where international capital, paired with government initiatives, can have the greatest effect on long-term economic growth.

The most well-established of these, and the sector which has historically underpinned Bahrain’s economic diversification efforts, is financial services. The sector is led by the banking segment, made up of 112 local, regional and international institutions which held aggregate assets of $192.7bn as of September 2016. Bahrain’s renowned regulatory environment has established it a popular destination for multinationals to conduct regional and global business from, including international giants such as Citibank, HSBC and Bank of China, and Middle Eastern players such as Arab Banking Corporation and National Bank of Kuwait (see Banking chapter). The financial sector also includes an Islamic banking segment, the assets of which expanded from $1.9bn in 2000 to $25.1bn in June 2015, and a thriving takaful (Islamic insurance) segment.

The kingdom is also home to a vibrant insurance and reinsurance segment comprised of 25 locally incorporated companies and 11 foreign firms, as well as an asset management industry that collectively operates nearly 3000 registered funds – the largest range in the region. All of these segments benefit from Bahrain’s large share of the GCC’s personal wealth, and the EDB estimates that the assets of high-net-worth individuals grew at a compound annual growth rate of 16% between 2010 and 2014, to claim 40% of the region’s total.

LOGISTICS: Looking beyond the financial industry, the EDB has its sights set on a wide array of economic activity. Logistics is a key target, thanks to the nation’s strategic location and status as a gateway to key international markets. “We had been working in Saudi Arabia for several years without a presence, but decided on Bahrain as a hub for activities because it is a tax-free, easy access market open that is open to business,” Alexandre Katrangi, partner and shareholder at Mocoh Bahrain, an oil distribution, logistics and trading company, told OBG. The Khalifa Bin Salman Port is the most efficient in the region, according to the EDB, with a container clearance time of less than three hours and a truck turnaround time of under one hour.

Companies wishing to establish distribution centres in the kingdom benefit from a liberalised regulatory environment and access to a direct entry point to the Eastern Province of Saudi Arabia through the King Fahd Causeway. The kingdom’s key logistics processing zones — Bahrain International Airport, the Khalifa Bin Salman Port, Bahrain International Investment Park and Bahrain Logistics Zone — are all located within easy reach of this vital international link, which since the 1980s has reduced the journey time to Riyadh to just four hours by car. A number of large logistics firms have already taken advantage of these factors, including TNT, UPS, DHL, Aramex, Agility, FedEx and Kuehne+Nagel.

MANUFACTURING: Bahrain’s growing logistics segment and transport links form part of Bahrain’s case for the expansion of a third strategic priority, manufacturing activity. Given the relatively small size of the domestic market, the kingdom’s trade and economic agreements with over 60 countries are a crucial element of the nation’s attractiveness as a manufacturing centre. These include agreements with France, Singapore, India and China, as well a free trade agreement with the US and a double taxation agreement with the UK. The government has also taken steps to ensure a plentiful supply of semi-skilled, skilled and specialist labour through programmes such as Tamkeen, a state labour fund that partners with businesses to improve the skills of Bahrainis. Other key incentives include 100% foreign ownership and 0% corporate tax across the kingdom.

An exemption from duties and duty free access to all GCC markets, meanwhile, allows locations such Bahrain International Investment Park (BIIP) to market themselves as offering companies a 5% margin against free zones in the GCC. Sizeable manufacturing companies which have already established themselves in Bahrain: include Reckit Benckiser, the consumer giant which includes household brands such as Dettol and Scholl within its portfolio; multinational chemicals manufacturer BASF; leading German industrial firm RMA; and Mondelez, the world’s leading maker of chocolate, biscuits, gum and candy, such as Oreo, Ritz and TUC biscuits.

The fourth target in the EDB’s economic expansion strategy, the ICT sector, forms part of the kingdom’s wider ambition to establish itself as a knowledge economy. Bahrain’s main advantages here are its deregulated telecoms market, which was the first in the region to be liberalised, and its extensive fibre-optic cable links to the rest of the region. Robust intellectual property laws are also an important factor to an industry which is based on innovation. In this regard the kingdom scores well in a regional context. The Bahrain Industrial Property Office was established in 1955, making it one of the oldest in Gulf, and it follows a broad mandate, which includes intellectual property as well as patents, design and trade marks. ICT companies that have established themselves in Manama include regional players such as Zain and Viva, as well as multinationals such as Hewlett Packard, Microsoft, TATA Consultancy Services and Huawei.

TOURISM RISING: Lastly, the EDB also considers the tourism and leisure sector ripe for future expansion. The King Fahd Causeway is filled with traffic each Thursday as a quarter-million residents of Saudi Arabia’s Eastern Province make their way to Manama to enjoy a more liberal social environment, but Bahrain’s longer-term ambition incorporates more than this local phenomenon. The kingdom’s attractions include a vibrant retail sector, which ranges from atmospheric souqs such as the Muharraq or the historic Bab Al Bahrain ,to high-end shopping centres, including the Moda Mall and Bahrain City Centre.

It also features a number of sporting attractions, including water sports, golf, an annual triathlon event and, most prestigious of all, the Formula 1 Gulf Air Bahrain Grand Prix, which has been a feature since 2004. Other attractions include a rich cultural and arts heritage dating back to the Bronze Age Dilmun civilisation, which today features two UNESCO World Heritage Sites, Qual’at Al Bahrain (Bahrain Fort) and the Pearl Route, as well as events such as the annual Spring of Culture and Bahrain Fine Arts Festival.

In terms of future growth, Bahrain aims to tap the GCC’s 36m consumers as well as the 400m in the wider MENA region — a market estimated to be worth $1.6trn. While a major goal is the building of more waterfront four- and five-star hotels, the EDB has identified a need for mid-range accommodation to meet growing demand for lower-cost holidays in the region, as well as a requirement for serviced apartments and villas to meet demand for affordable family-based tourism.

SME: Bahrain’s diversification efforts run vertically as well as horizontally. The government has expended considerable energy in encouraging the growth of smaller businesses, in doing so establishing the country as a regional pioneer in SME policy.

For example, the Arab Regional Centre for Entrepreneurship and Investment Training has existed in Bahrain since 2001, established by the UN Industrial Development Organisation and an Indian government entrepreneurship organisation.

Over the past decade the Ministry of Industry and Commerce has worked with other government bodies to enhance the environment for the nation’s smaller companies, simplifying setup procedures, implementing effective and transparent regulations, building industrial infrastructure and parks, and ensuring the availability of industrial land at a competitive price.

Recently, more focused assistance for SMEs has come from the Bahrain Chamber of Commerce and Industry, which in 2013 launched its new SME Development and Support Centre, providing services in areas such as regulatory advice, export operations, business processes (including quality management, franchising, supply chain management, risk assessment and subcontracting), access to funding, and establishing partnerships with regional and international SME organisations.

The Bahrain Development Bank, meanwhile, has extended its activities beyond just simple funding to include its own set of non-financial services in the form of its Rowad Accelerator Programme, offering entrepreneurs a support platform that includes coaching, training, incubation and funding.

Tamkeen is another major pillar of SME development in Bahrain and it pursues two principal objectives: encouraging the creation of enterprises, and providing the support necessary to further increase the productivity of existing companies.

Its most significant contribution to the SME sphere is the finance scheme it has developed in collaboration with an array of Bahraini banks. Under this scheme SMEs are granted access to sharia-compliant facilities at a competitive profit rate.

In addition, Tamkeen subsidises 50% of the annual profit rate, up to a maximum 8% on the reducing balance. Financing packages range from BD5000 ($13,300) to BD500,000 ($1.3m), with tenors extending up to 10 years, depending on the purpose of financing, and a grace period of one month to two years, subject to the bank’s policy.

TRADE: Both the broadening of Bahrain’s economic base and the development of its smaller businesses promise to usefully diversify the kingdom’s trade basket. Bahrain’s recurring trade surplus over recent decades has largely rested on its oil sales, which between 2011 and 2014 accounted for approximately 65% of the total trade exports.

However, low oil prices reduced this figure to 44.4% in 2015, a trend that was largely responsible for the kingdom’s current account falling into the red that year – at a deficit of 3.1% – highlighting the need for a wider array of export activity. Perhaps the kingdom’s key advantage as it sets about boosting its non-oil exports is that the entire country is effectively a free zone, and even commercial companies operating from dedicated areas such as the BIIP enjoy duty free access to all GCC markets, unlike those located in free zones elsewhere in the Gulf.

Currently, non-oil exports from Bahrain are dominated by aluminium, the global price of which has also declined, followed by steel and light manufacturing products. More than half of them are destined for the GCC, with Saudi Arabia being the single biggest recipient, claiming 35% of Bahrain’s non-oil exports.

On the other side of the ledger, major non-oil imports to Bahrain include iron ore and concentrates, machinery and automobiles, electrical appliances and food and other consumer products. China is Bahrain’s main import partner, while other important import sources include Brazil, the US and the GCC.

MONETARY POLICY: For a small trading nation such as Bahrain, monetary policy is crucial to facilitating trade with global partners. Since the 1980s a high degree of rate stability has been maintained through a dollar peg — set at BD0.376:$1 and unchanged since — which has also facilitated trade with regional partners with similar ties to the US currency. The primary objective of Bahrain’s monetary policy is to maintain adequate liquidity in the banking sector.

To this end, the CBB provides a foreign exchange facility that is used to sell and buy Bahraini dinars against the US dollar at the official exchange rate, while it aims to steer short-term interest rates in the market by providing deposit and standing facilities to banks. In December 2016, the CBB raised 1 week key policy rate from 0.75% to 1%, and raised overnight deposit rate from 0.50% to 0.75%. Inflation grew from 1.9% in 2015 to 2.7% in 2016, driven by price rises in water, electricity, gas and other fuels. The EDB estimates inflation for 2017 to return to a moderate 2%, with a similar rate predicted for 2018.

OUTLOOK: Bahrain faces a period of slow economic growth over the next year. Estimates regarding GDP expansion vary, but most broadly concur with the World Bank’s prediction of 2% for 2017.

The fiscal deficit is likely to remain in place over the medium term, according to the World Bank, running at 15.3% of GDP in 2017, which represents a marginal improvement on the previous year.

From a financial stability standpoint, Bahrain’s economy benefits from its close relationship with its GCC neighbours. The Gulf Development Fund has played a central role in maintaining a project pipeline, which is of great importance to economic activity within the kingdom.

In 2016 Alba announced that it had received financial commitments worth $1.5bn from banks for the development of its Line 6 expansion project, which have allowed it to award construction contracts for an independent power station to a consortium of GE and Turkey’s Gama Power Systems.

Elsewhere, work has begun on Muharraq Island, which will include a new central market along with a multipurpose development that will connect the old souqs with the waterfront.

Other significant developments include the airport expansion, social housing projects funded by the Gulf Development Fund and a gas plant, which is expected to increase aggregate capacity by 350m cu feet. In the meantime, the government is likely to press ahead with the challenging processes of subsidy reform and revenue boosting in a bid to further safeguard its fiscal standing going forward.