Challenges to Bahrain's sovereign ratings increase

But while downside risks have increased, a change in the rating or stable outlook is not yet warranted given the strong starting position for the public and external finances, the authorities' track record of sound macroeconomic management, and Capital Intelligence's expectation that oil prices will trend higher over the medium term.

Capital Intelligence notes that the state budget has been in surplus for the past six years, thanks to high oil prices and careful expenditure management. As a result, the government's balance sheet has strengthened and its capacity to absorb economic shocks has increased.

According to Capital Intelligence's estimates, the budget achieved a surplus of around 5.7% of GDP in 2008 while central government debt fell to just over 17% of GDP from 19% a year earlier.

With oil accounting for around three-quarters of total revenue, the steep decline in the price of oil over recent months will have a pronounced effect on the fiscal position in 2009. The government's biennial budget plans, which have yet to be approved by parliament, envision deficits in the range of 2%-3% of GDP in 2009 and 2010, but are based on an oil price assumption of $60 a barrel for each of the two years. While it is possible that the price of oil will reach the assumed level in 2010, it looks increasingly likely that the actual oil price will be closer to $40 a barrel this year. If so, the budget deficit for 2009 could be three times bigger than planned.

The outcome could be less pronounced if the government reduces spending in the near term, but this is likely to prove challenging as the budget plans already incorporate large cuts in capital expenditure and there is substantial political pressure for higher-than-budgeted social expenditure (to be partly financed by increased transfers from state-owned entities).

Assuming an average oil price of $40 a barrel and minimal additional fiscal effort, Capital Intelligence forecasts a central government deficit of 8.5% of GDP in 2009, declining to 3% of GDP in 2010 provided the average oil price reaches $60 a barrel and spending does not overshoot the targeted level.

Capital Intelligence expects the government to meet its enlarged gross financing requirement through a combination of debt issuance and the draw down of its liquid financial assets, which include bank deposits amounting to around 14% of GDP. Central government debt is projected to rise to 23% of GDP in gross terms by end-2010 and to 11% of GDP net of deposits - levels that would still be consistent with Bahrain's current credit rating.

Although manageable in the short term, budget deficits of the magnitude projected are not sustainable and the sovereign's rating is likely to come under increasing pressure if the oil price does not reach the estimated breakeven level (under unchanged policies) of $75 a barrel by 2011 or if insufficient steps are taken over the next 12-18 months to rein in the non-oil deficit. The ratings could also come under pressure in the event of a further slump in the oil price from current levels in the short term.

In Capital Intelligence's opinion, risks to sovereign creditworthiness from the financial system are not high at present and the banking sector has weathered the global financial turbulence relatively well.

Two large wholesale banks reported substantial losses in 2007 due to their exposure to the US subprime mortgage market but were subsequently recapitalised by shareholders, which in the case of one of the banks included the government of Bahrain. So far most other banks have not had any significant problems and the government has not had to provide any extraordinary support to the sector beyond moderate liquidity support.

Nevertheless, vulnerabilities have risen. For wholesale banks in particular, refinancing risk has increased due to the tightening of global liquidity, and profitability and capitalisation are under pressure from falling equity and real estate prices throughout the region and in the world's major economies. The principal risks to retail banks stem from a deterioration in asset quality and weakening profitability as the domestic economy slows and local property prices correct. Private sector credit growth has been very strong over the past few years and the retail sector's exposure to real estate is high at around one-third of total loans.

Capital Intelligence believes the authorities would likely provide financial assistance to governmentowned or systemically important retail banks should such support be needed, but may be unwilling or unable to provide any significant support to wholesale banks, many of which are subsidiaries or branches of foreign institutions.