Bahrain: Competition to increase

The near-term economic outlook remains avourable. High oil prices and continued diversification efforts are expected to boost economic activity by 6% in 2006 after an estimated 6.8% in 2005.

On the latter, the government is expanding downstream activities such as aluminium production with a sixth podline capable of producing 300,00 tonnes a year under consideration after an expansion has just been completed.

Other projects include the construction of the KFH Industrial Oasis and the expansion of the independent water and power project at Hidd. Meanwhile, Bahrain is also trying to further leverage its position as a service provider for Saudi Arabia. Such efforts include the building of the Financial Harbour and the opening of the Hidd port.

The Bahrain Financial Harbour is a key project to propel the country as the Islamic banking hub of the world, a position Bahrain has cultivated in recent years. This space is growing faster than conventional banking sector. Meanwhile, it has just been announced that the world's largest Islamic bank, Al Masref Bank, should soon be created with a start-up capital base of USD 5bn compared to the next largest, Saudi Islamic Bank, with paid-up capital of USD 1.8bn. With most of the investors apparently being from Bahrain, and given the country's leading role in this niche segment, it would appear to be a good assumption that the bank will be based in Bahrain.

All this sounds positive. However, there are still longer term risks to the economic outlook. The key question being asked is whether the economy is going to create sufficient jobs for the fast-growing labour force. While this is a problem for the region as a whole, the more populous countries such as Egypt, Iran and Saudi Arabia are of more concern. That said, unemployment is already a problem in Bahrain and is causing some, albeit relatively minor, social and political tensions.

Looking at some of the diversification efforts does not alleviate these concerns. For instance, one has to question just how many jobs will be created by Alba's expansion as this is a capital intensive rather than a labour intensive industry. Meanwhile, the expansion of the financial sector will create jobs, but whether they will be filled by the local workforce rather than by expatriates remains uncertain.

Of course, any expansion in the economy and in the population creates spin-off jobs in other areas. And the good news is that the local workforce is generally happy to take the jobs that are available. However, whether job creation will be sufficient to satisfy the country's needs is doubtful.

In some of the GCC countries, e.g. Kuwait, this is not seen as a huge problem. Huge hydrocarbon revenues and the associated fiscal surpluses have meant that any failure to create jobs could be offset by increased public sector jobs and welfare state spending.

However, for Bahrain this is less of a policy option. While high oil prices have pushed the fiscal accounts into a surplus, the surplus as a percentage of GDP is lower than elsewhere and some estimates of the breakeven level of oil prices from a fiscal perspective is USD 36 per barrel, compared to below USD 30pb for its GCC counterparts.

The good news is that we expect oil prices to average USD 40pb over the long-run which should allow the government room to maneuver on spending while also allowing a gradual reduction in the level of government debt, particularly as a percentage of GDP.

Therefore, we expect trend rowth in nominal USD GDP to be around 7.8% CAGR over the course of the next five years, despite the fact that oil prices are likely to fall gradually over this forecast time horizon. However, while we expect the non-oil sector to be the driver of growth, this forecast is still sensitive to oil price assumptions given the need for oil money to fund non-oil growth to a significant extent.

The key other risk facing the economy is increased competition. Dubai is becoming an increasing competitor in the financial sector pace. The setting up of the Dubai International Financial Centre (DIFC), and its attempt to become the region's financial centre, will for the first time give a real alternative to Bahrain's very well regulated financial sector. There are still a lot of question marks surrounding DIFC, but we expect it to start showing significant progress in 2006-7.

This raises the question as to whether there is enough room for both centres to play an expanding role. As long as Bahrain focuses on its core competence of Islamic banking, we believe the centre will grow significantly in the coming years, alongside a strong performance in the UAE. Meanwhile, the fact that the cost of living in Bahrain is significantly lower than that in Dubai should help its competitive position.

The other longer-term risk for the financial centre is the fact that it relies heavily on business in Saudi Arabia. As the Saudi banking system opens up, it is possible that some banks will move across the border and operate in Saudi Arabia itself.

While some migration is likely over the medium-term, the need to attract expatriates, who generally would much prefer to have themselves and their families in Bahrain, means that this is a long-term risk, but not a short-term one. Indeed, the situation is very similar with China and HK. Many have feared for some time that HK would be replaced by Shanghai as North-East Asia's leading financial centre.

Despite a dramatic improvement in the infrastructure and standard of living in Shanghai in recent years, HK continues to thrive. Saudi Arabia is, in our opinion, many years behind Shanghai in terms of its ability to attract expatriates into the banking sector. Therefore, the Bahraini financial sector appears to have a positive outlook for the foreseeable future.

The final competitive risk is in the tourism industry. Most countries in the region have a desire to boost tourism. Again Dubai has done an incredible job in this area, but in this case it is far from being alone with Qatar, Oman and Abu Dhabi spending a lot of money to boost their tourism sectors. Of course, Bahrain's location gives it an advantage for tourism flows from Saudi Arabia to continue growing going forward.

However, more needs to be done if Bahrain wants to be a recipient of tourists from outside of the region. Overall, we look for a buoyant multi-year outlook for the Bahrain economy, but now is not the time to take the eye off the reform and diversification balls. Competition is only likely to increase and Bahrain needs to ensure that it consolidates its current strong position in the areas of finance and tourism.