MANAMA (Reuters) - As the weekend kicks off in Bahrain, Saudi Arabian and Kuwaiti cars jam the capital’s roads and hotel lobbies fill with visitors looking for bars, restaurants and other night-time entertainment.
A new sales tax introduced this year means government coffers will gain with every glass of wine sold and shisha pipe smoked, but that’s still not enough to plug a large gap in the island kingdom’s finances and wean it off aid from richer neighbors.
Saudi Arabia, along with Kuwait and the United Arab Emirates, came to the rescue of Bahrain last year when a prolonged period of lower oil prices pushed its public debt to nearly 93 percent of annual economic output.
Their $10 billion bailout pledge, along with Bahrain’s inclusion in JPMorgan’s emerging market indexes, have transformed its bonds from a busted bet to a boon for investors.
The price of Bahrain’s 2028 dollar bonds has risen by a third from a record low last June when the country looked in danger of default. But that upward trajectory could go into reverse if Manama does not tackle its spending overruns.
With an overall deficit last year equivalent to 11.7 percent of annual economic output, according to an estimate by the International Monetary Fund (IMF), Bahrain would need to introduce a raft of new taxes and spending cuts to eliminate its budget deficit by 2022, a target set as part of its bailout.
But the country’s Sunni Muslim royal rulers are wary of austerity measures roiling sectarian tensions among their Shi’ite majority populace and of taxes, fees and spending cuts dampening growth.
Instead, the government has set its sights on trying to grow the local economy to boost revenues and balance the books.
Investments in the fintech sector, a major oil and gas find and the development of Bahrain as a hub for foreign companies wanting to tap into the larger Saudi Arabian market are all initiatives touted by the government as future sources of revenue.
But they are not seen as sufficient to close the gap by 2022. The IMF said this month that it expects the economy to grow around 1.8 percent this year, the same pace as last year, and said additional reform efforts were needed.
“We still think there will be deficits at the end of the period,” said Trevor Cullinan, sovereign credit analyst at Standard & Poor’s, which like the other main rating agencies has a junk rating on Bahrain’s debt.
Bahrain’s ministry of finance and national economy said the country’s fiscal program was on track to deliver a balanced budget in 2022.
“This is a comprehensive and credible plan which, through a combination of spending reductions and revenue measures, is already delivering significant progress,” the ministry said in a statement
A recovering oil price, along with new excise taxes and cuts in subsidies for water and power consumption have helped shrink Bahrain’s deficit from a record 18.4 percent of gross domestic product (GDP) in 2015.
As part of the bailout from its Gulf allies, Bahrain agreed to introduce a 5 percent value added tax (VAT), as well as further subsidy cuts and a voluntary retirement plan for state workers.
But the government has ruled out taxing income or company profits, partly to continue attracting business to a region where such taxes are non-existent.
Bahrain’s government is also wary of the population’s long history of political protest. Most recently, it quashed an uprising in 2011 with the help of Saudi Arabia, which fears unrest in its smaller neighbor would encourage dissent among its own population and Shi’ite minority.
The plunge in the oil price has forced all Gulf states, including Saudi Arabia, to re-think generous welfare programs and push economic diversification harder.
Bahrain, which does not have the vast oil wealth of its neighbors, discovered a large oil and gas field off its west coast last year and is in talks with U.S. oil companies about developing it.
The discovery could be an important source of revenue but its benefits are unlikely to materialize soon as converting the estimates to reserves is a costly and lengthy process.
“It takes a minimum of four to five years, so if you’re going to get any revenue it’s not going to be immediate, so you still have to face the adjustment to a large fiscal deficit and a large budget deficit,” said Nasser Saidi, a Dubai-based economist.
In the meantime, Bahrain has been trying to market itself as a financial technology hub for the Middle East and North Africa. Last year, it inaugurated Bahrain FinTech Bay, a state-backed platform, offering technology companies office space, networking events and a mobile app for collaborations.
FinTech Bay’s chief executive, Khalid Saad, said the initiative would be a “great contributor” to Bahrain, but said it was too early to quantify that contribution.
Saad said the hub had so far attracted 36 firms — 60 percent of them international — to work on technologies such as digital currency and blockchain-based payments.
S&P has not factored in any contribution from the fintech initiative in its estimates for Bahraini economic growth.
“How much more are you going to get from fintech? Are you going to add 1 or 2 percent of GDP? I don’t think so, it’s not a big employment generator,” said Saidi.
Amazon Web Services (AWS), the world’s biggest cloud computing provider, is opening a regional data center in Bahrain later this year. The company has declined to say how many people it will employ but Zubin Chagpar, the head of public sector for Amazon Web Services in the Middle East said the government’s willingness to focus on digital transformation was a key factor in Amazon’s decision to locate there.
“Bahrain is very particular in saying they want to leverage technology to redefine our economy,” Chagpar said.
Leveraging its proximity to Saudi Arabia has been part of Bahrain’s economic toolkit since a bridge connecting it to Saudi Arabia’s Eastern Province, where oil giant Aramco is headquartered, was opened in 1986.
Some 1.1 million people entered Bahrain via the bridge in January, many attracted by the country’s more relaxed rules on drinking and socializing. Unlike Saudi Arabia and neighboring Kuwait, where alcohol is prohibited, alcoholic drinks are sold in Bahrain. Some international companies, which want to sell into the Saudi market, also base themselves in Bahrain, where the operating costs are cheaper. U.S. manufacturer Mueller Industries and Mondelez, the world’s No 2 confectioner, have recently expanded their presence in Bahrain.
But Bahrain’s prime position as a “stepping stone” to Saudi Arabia could wane given the fast pace of change in the conservative country as it moves to relax social restrictions and build entertainment and tourism industries. It is also developing its own manufacturing sector.
“It used to make sense four or five years ago, it doesn’t make sense now that Saudi Arabia has opened up,” said Saidi.
Editing by Carmel Crimmins