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Dividing opinion

July 2012

To what extent will closer union between Saudi Arabia and Bahrain deliver much-needed benefits for the island nation’s struggling economy?

by Rosamund de Sybel
[email protected]

When Gulf leaders gathered in Riyadh in May to discuss developing the six-nation Gulf Co-operation Council (GCC) into a union, expectations of an historic announcement ran high. Media speculated that plans for a tighter political union – championed by Riyadh and beginning with Saudi Arabia and Bahrain – would be approved. The meeting was expected to herald a gradual move toward deeper political, economic and military integration of the GCC, designed partly to protect the Gulf Arab states from the machinations of Tehran, and partly from the potential for domestic political upheaval.

But the summit came and went with more rhetoric than substance. Though promises for further consultation were made, terms of the proposed union remain hazy.

The political message however, was eagerly embraced by the more conservative elements of Bahrain’s government. The kingdom’s long-serving prime minister, Prince Khalifa bin Salman al Khalifa, said that the “option of a union has become urgent,” adding that GCC states must cooperate to ensure security in the region.

Riyadh has become increasingly worried that political turmoil in Bahrain – which has simmered since Saudi troops were called in to quell Shia-led protests against the Sunni ruling Al Khalifa family last year – could spill over into its own Shia-populated oil-producing Eastern Province, just 25 kilometers from Manama.

To many observers the idea of a union in which Bahrain could become a quasi-independent Saudi province – which some expected to be designed along the lines of a Hong Kong-China model – appeared fantastical. To others, it represented a silver bullet for conservative elements of the tiny kingdom’s government: promising to bring domestic stability by folding Bahrain and its political crisis into the region’s most powerful Sunni country. Such a union, proponents suggested, would also bring a host of lucrative economic benefits to the island.

Yet the arrangement would be far from palatable for many Bahrainis, or their neighbours on either side of the Gulf, say analysts.

“Even for Bahrain, a state which clearly needs a great amount of support from Saudi Arabia, a close political union would likely enrage the Shia majority and many in the Sunni minority too might be less than thrilled if it is perceived that Bahrain is surrendering chunks of its sovereignty to Riyadh,” says David Roberts, deputy director of the Qatar branch of the Royal United Services Institute (RUSI), a British think tank.

Despite the unprecedented show of GCC unity heralded by the Arab Spring, any political union and concomitant loss of sovereignty would likely be repellent to many Gulf leaders. Plans for less ambitious integration have come unstuck relatively easily in the past. In 2009 the United Arab Emirates pulled out of GCC monetary union, after it was decided that the central bank would be based in Saudi Arabia rather than Abu Dhabi. At the time, commentators pointed to the inability of Gulf governments to overcome political rifts in order to usher in the benefits of financial and economic integration. Even in the aftermath of the Arab Spring, any plan for a Gulf federation, the governing body of which would be in Riyadh, would be a hard pill to swallow.

“The million dollar question is: what will happen?” asks Roberts. “Bahrain might submit itself to some kind of watered down ‘union’ plan. Qatar too might pay lip service to the plan. The UAE, Oman, and Kuwait, though, will not submit themselves to anything approaching a meaningful union which surrenders powers to Riyadh.”

Indeed, he says, “greater union is an exceedingly difficult thing for the smaller states to contemplate.”

Should Bahrain decide to formally tether itself to Saudi Arabia, the road to union would be bumpy one. Thousands marched in Bahrain in May to voice their opposition to the idea of a Bahrain-Saudi confederation. Iranians also took to the streets to denounce the plan. The proposal has served to further inflame tensions between Saudi Arabia and the Islamic Republic, which GCC officials accuse of backing Bahrain’s opposition groups.

The potentially grave political costs aside, a confederation on the face of it would present psychological economic benefits for Bahrain, reinforcing the generally held belief that Saudi Arabia stands four-square behind it, and would step in should it need to.

“The economic impact on Bahrain is more psychological,” says Farouk Soussa, Citi’s chief economist for the Middle East. “A union would cement in the minds of investors the notion that Saudi stands behind Bahrain, which it has done for many years. It would therefore encourage direct and portfolio inflows into Bahrain, helping the economy and supporting the country’s relatively weak public finances.”

The island’s economy has suffered in recent years. As it strained beneath the effects of the global financial crisis, its banking sector was pummeled by the fallout from the multibillion-dollar dispute between two Saudi conglomerates, Saad and Algosaibi. Bahrain has also lost much of its perceived competitiveness to the dynamism of Qatar and Dubai. Last year, as it was buffeted by the impact of a failed uprising and ensuing political instability, its credit rating was slashed. Bahrain is now rated ‘Baa1’ by Moody’s and ‘BBB’ by Standard & Poor’s and Fitch.

Bahrain lacks the financial cushion of some of its richer neighbours, and was unable to offset dissent with the generous social welfare packages proffered by its neighbours. Its welfare spending has nevertheless spiraled upwards to unsustainable levels. An April report from the International Monetary Fund (IMF) noted that Bahrain’s break-even oil price reached $114 per barrel in 2011 – the highest level in the GCC – compared to just $80 in 2008. Expenditure commitments were increased permanently through wages and associated allowances – a 15 per cent salary increase for all civil servants in August – and transfer increases as well as via one-off cash transfers, according to the IMF.

The impact on the 2011 budget was, however, offset by a sharp increase in oil revenues. Around 70 per cent of Bahrain’s government revenues come from Saudi Arabia’s Abu Safah oil field, under a decades old agreement. Despite high oil prices for 2012 the government had forecast a budget deficit of 8.8 per cent of GDP due to slightly lower spending, which at BD3.1 billion ($8.2 billion) was 14 per cent higher than originally planned.

Among Bahrain’s most pressing concerns is job creation; it desperately needs to boost the private sector, rather than succumbing to the temptation of swelling the civil service. The latest data available on Bahrain’s Labour Market Regulatory Authority website for the first quarter of 2011 showed that 141,263 Bahrainis were employed, about a third of whom worked for the government.

“This is not primarily about whether Bahrain can reemerge as the leading regional financial centre. It’s about whether they can generate enough growth, to create areas of competitiveness which can generate new jobs,” says Jarmo Kotilaine, chief economist at Saudi Arabia’s National Commercial Bank (NCB). “But Bahrain’s size is one of the sources of its resilience; you don’t need massive amounts of investment to stabilise the situation.”

He emphasises that Bahrain’s key competitive advantage is its ability to service Saudi’s Eastern province, “whether through the airport, the port, or various kinds of financial and ancillary services it can provide.

“It’s clearly an opportunity for the country to leverage its strength in the local context. It can serve as a frontline for much of Eastern and Central Saudi Arabia,” he argues. He points to areas such as Islamic finance, insurance, or other ancillary services that Bahrain could develop. Bahrain can also leverage its well-developed regulatory system. Yet as Saudi Arabia has liberalised its economy, relaxed its policy barriers and developed its own financial system, Bahrain may struggle to make itself relevant.

“There might be a role for Bahrain as Saudi Arabia’s offshore finance centre, but it would be limited since Saudi has its own financial system that is currently adequate for its needs,” says James Reeve, senior economist at Samba Financial Group, a Saudi bank. “Most of the projects – even the big ones – are financed in Saudi riyals. There may be scope for using Bahrain as a place from which to source foreign currency, but to be honest, the Saudi banks can provide quite a bit, and the Saudi government is flush with dollars.”

He argues that the idea of Bahrain becoming to Saudi Arabia what Hong Kong is to China, is flawed.

“I’m not sure that Hong Kong is really applicable to Bahrain. Hong Kong’s utility lies in its position as a place from which to finance trade with China, but that’s largely because the renminbi is not freely convertible. The Saudi riyal is. Anyone can trade with Saudi, and they don’t need to go through Bahrain to do it.”

Primarily, a union would therefore boost investor confidence by reinforcing the fact that Bahrain’s debt and fiscal position were ‘underwritten’ by Saudi Arabia.

“This should give some confidence to potential foreign investors, given Saudi Arabia’s huge energy resources. Perhaps foreign investors currently look at Bahrain and think its politics is unstable and its fiscal position is dicey. Having an explicit Saudi guarantee may allay fears about the second part of this equation,” observes Reeve.

This could in turn lead to enhanced foreign investment in services, creating the sorts of jobs that Bahrain needs. Yet the country will need to fix its political situation first, and few are convinced that forming a confederation with Saudi Arabia would achieve that.

On close scrutiny, Bahrain-Saudi union appears, like the curate’s egg – that the negatives could outweigh the positives.

Bahrain: Selected Economic and Financial Indicators, 2006-11
2006 2007 2008 2009 2010 2011

(Percent change, unless otherwise indicated)

Production and prices
Real GDP 6.7 8.4 6.3 3.1 4.1 1.8
Real oil GDP 1 -1.0 1.1 0.4 -0.3 0.1 4.1
Real non-oil GDP 8.1 9.6 7.2 3.6 4.6 1.5
Nominal GDP (in billions of US dollars) 15.8 18.5 22.1 19.3 22.7 26.5
Consumer Price Index (period average) 2.0 3.3 3.5 2.8 2.0 1.6

(In percent of GDP, unless otherwise indicated)

Financial variables
Total revenue 30.9 29.3 32.4 23.8 25.8 27.7
Of which: Oil revenue 23.8 23.5 27.7 19.8 22.0 24.3
Total expenditure 26.1 26.2 24.7 28.7 30.9 28.5
Overall fiscal balance 2.7 1.9 4.9 -6.6 -6.6 -2.3
Change in broad money (in percent) 14.9 40.8 18.4 6.5 11.7 0.9

(In billions of US dollars, unless otherwise indicated)

External sector
Exports 12.2 13.6 17.3 12.1 13.6 16.8
Of which: Oil and refined products 9.2 10.8 13.8 9.1 10.2 12.9
Imports -10.0 -10.9 -14.2 -9.6 -11.2 -11.6
Current account balance 2.2 2.9 2.3 0.8 0.8 1.1
In percent of GDP 13.8 15.7 10.2 4.1 3.4 4.2
Gross official reserves (end period) 2.7 4.1 3.8 3.5 4.8 4.2
In months of imports (including crude oil imports) 2 22.6 3.1 4.1 3.3 4.3 3.6
In months of imports (excluding crude oil imports) 2 25.1 7.6 5.4 6.3 7.8 7.6
Real effective exchange rate (percent change) -2.9 -7.0 15.4 4.5 -2.4 -5.7
1 Includes crude oil and gas.
2 Imports of goods and non-factor services for the following year.

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