Moody’s downgrades Bahrain sovereign ratings to A3

Moody's Investors Service has downgraded Bahrain's local and foreign currency government bond ratings to A3 from A2, with a stable outlook, due to a gradual but significant rise in the breakeven oil price in the Bahraini budget over recent years. This, together with a relatively modest level of official financial assets, has led to a divergence between the government's fiscal flexibility and that of rating peers.
The rating agency added that “this reduced fiscal flexibility makes it more challenging potentially to meet contingent liabilities arising from Bahrain's financial sector, which is relatively large compared with the government's resources.”
Moody's maintains a negative outlook on Bahrain's banking system.
"Bahrain's credit fundamentals, while robust and still within the A category, have diverged in some respects from those of rating peers. Published fiscal data imply that the oil price necessary to balance the budget has gradually risen over time. Additionally, Bahrain's cushion of official financial assets is thinner than that of other investment-grade commodity exporters. This exposes the country's public finances to a degree of risk that, in Moody's opinion, is better reflected by an A3 rating," explained Tristan Cooper, Moody's Head Analyst for Middle East Sovereigns.
Published fiscal accounts indicate that the oil price necessary to balance the budget in Bahrain has risen in recent years from levels which Moody's estimates to be approximately $30 per barrel in 2004 to almost $80 per barrel in 2009 (for the benchmark Brent crude). This trend is largely due to upward pressure on current expenditure, which has restricted the government's room for manoeuvre. Although capital expenditure can be cut in some years to offset revenue shortfalls (as it was in 2009), Moody's noted that such reductions cannot usually be sustained without damaging growth prospects.
"While acknowledging Bahrain's high level of GDP per capita and its good progress toward economic diversification, the government's ability to generate revenues from the non-oil sector is hampered by its narrow tax base," added Cooper. The government's ability to widen its tax net, which remains heavily dominated by oil receipts, is constrained by the absence of personal income tax and VAT. These would be difficult to introduce given the tax-free status of neighbouring Gulf countries.
Moody's also has some concerns about the performance of Bahrain's financial sector, which is large in relation to the government's resources. In August, the rating agency reiterated its negative outlook on Bahrain's banking system, reflecting the ongoing weaknesses in the domestic and regional real-estate sectors, to which banks maintain significant exposure. Moody's has downgraded the ratings of a number of banks in Bahrain over the past two years.
The rating agency recognises that riskier wholesale banks present only a limited contingent liability for the government given the restrictions on their interaction with residents. However, the retail banking sector is also extensive, with assets worth approximately three times GDP. Moody's believes that, over the longer term, Bahrain's banking sector will increasingly face competition as other regional financial centres develop.
Bahrain's ratings are supported by the country's relatively robust economic strength, positive net international investment position and effective regulatory environment. Strong international alliances are also a credit positive, particularly those with Saudi Arabia and the US, which would be expected to potentially assist the government in case of difficulty. However, Moody's notes domestic political tensions, which could rise in the run-up to parliamentary elections in October, as well as elevated regional geopolitical risk.