DESPITE ECONOMIC DIVERSIFICATION, BAHRAIN SHARES

UNCLAS SECTION 01 OF 02 MANAMA 000521

SENSITIVE
SIPDIS

BAGHDAD FOR AMBASSADOR ERELI

E.O. 12958: N/A
TAGS: ECON EFIN GCC BA
SUBJECT: DESPITE ECONOMIC DIVERSIFICATION, BAHRAIN SHARES
OIL-BASED INFLATION PRESSURES WITH GCC

REF: A. MANAMA 44

B. MANAMA 76


1. (U) Summary: Although Bahrain's economy is not as
dependent on petroleum exports as its GCC neighbors, it does
feel similar inflationary pressures from rising oil prices.
Bahrain's disproportionate susceptibility to petroleum-driven
inflation is largely due to a combination of Central Bank
policies, GOB fiscal policy--which is closely tied to oil
revenues--and the strong inter-relation of the Bahraini
economy with Saudi Arabia. Due to the diversification of its
economy, Bahrain's inflation will likely remain the lowest in
the Gulf, but upward pressures may push it far beyond recent
expectations. End summary.

Background
--------------

2. (U) Unlike its GCC neighbors, petroleum and
petroleum-related products account for less than 30% of
Bahrain's GDP. Despite the smaller role oil appears to play
in the overall economy, petroleum revenue accounts for almost
80% of Bahrain's central government revenue, which in turn
was 25% of GDP in 2006. Bahrain derives its petroleum
revenue from both onshore and offshore operations. Onshore
oil production is relatively constant at about 182,000
barrels per day and does not appear to respond to price--this
oil accounts for approximately 20% of all Bahrain's oil
revenue. The remaining oil income is revenue from the joint
Saudi-Bahraini offshore Abu Safa field. Saudi Arabia
administers the field and provides Bahrain its share in
cash--the amount of which remains undisclosed (ref A). Since
Bahraini oil volumes do not appear to react to changes in the
market, central government operating revenue is basically a
direct function of oil price.


3. (SBU) Inflation figures for Bahrain vary widely. The
Consumer Price Index (CPI)--determined by the GOB Central
Informatics Organization (CIO)--has varied between 1.6% and
2.6% since 2003, while the GDP deflator, as reported in the
International Monetary Fund's International Financial
Statistics (IFS) has moved between 7.1% and 11%. Although
both measurements of inflation have their weaknesses, the CPI
is particularly suspect due to CIO's relative lack of ability
to accurately measure inflation, lack of transparency in
their calculations, and political pressures on the CIO to
show low inflation rates. (Comment: The CIO's credibility is
especially low with Bahrain's political opposition, who
believe the CIO was caught red-handed under-reporting the
number of Sunnis quietly naturalized in Bahrain (ref B). End
comment.) The GDP deflator on the other hand, which simply
measures the difference between the chain-volume measure of
the GDP and the nominal change, misses the change in prices
of imports into the economy, the value of which have not been
below 60% of GDP as long as records have been kept.


4. (U) Regardless of the inflation measurement used,
inflation pressures not only increase as government revenues
from oil increase, but also as oil revenues in Saudi and
other GCC states increase, and those foreign funds find their
way into the Bahraini economy. The level of effect that
those GCC funds have on the Bahraini economy is largely
dependent on the actions of the Central Bank.

Fiscal Policy ) restraint limited?
--------------

5. (SBU) GOB spending historically accounts for approximately
25% of Bahrain's GDP. Out of fear of inflationary pressures,
the GOB has generally exercised fiscal restraint. According
to IFS data, while revenues, as a share of GDP, have grown by
more than eight percent per year since 2005, government
spending, as a share of GDP, has remained fairly constant and
has even declined slightly. That restraint may have now
reached its limit as there are growing demands for local
infrastructure improvements and social programs. While
projections from economic analysts such as Global Insights
typically use assumptions that GOB spending will increase at
approximately five percent per year, officials in Parliament
and the Economic Development Board familiar with the 2008
draft budget indicate government spending may increase by as
much as 20% in 2008, growing government spending to almost
30% of GDP.

Monetary Policy ) loose control over M1
--------------

6. (U) The Central Bank of Bahrain (CBB) does not appear to
actively attempt to sterilize foreign currency flows.
According to IFS data, since 1990 the CBB has held foreign
assets, as a share of GDP, fairly constant. Prior to 1990,

MANAMA 00000521 002 OF 002


foreign assets fluctuated wildly in response to markets,
reaching as high as 52% of GDP in 1986. By 2005, foreign
assets were down to less than 17% of GDP, and have not
fluctuated outside a range of 500 basis points since 1999.
Prior to 1990, the government apparently offset foreign asset
fluctuations with changes to central government deposit
accounts--or quite simply, the government horded excess
earnings to keep the money out of the economy. After 1990,
as foreign asset holdings dropped and stabilized, central
government deposits also dropped and stabilized, and there is
no indication that the CBB issued bonds or other government
securities to offset foreign assets. To further exacerbate
the effects of not sterilizing, although not officially
allowed, Saudi riyals circulate widely in Bahrain alongside
the Bahraini dinar. Most retailers and service providers
will accept riyals to settle accounts. As a result the CBB
has only a loose control over the actual currency-used in
circulation.

Close Saudi ties extend to inflation
--------------

7. (U) A sharp increase in the price of oil directly affects
not only the balance sheet of Bahrain, but also that of its
massive oil producing neighbor Saudi Arabia. Saudi Arabia
has long-established commercial ties with Bahrain, and is
Bahrain's primary trading and investment partner--when there
is an increase in Saudi wealth, there is a corresponding
increase in money spent in Bahrain. This money comes as both
investment as well as direct consumption--Saudi Arabia
accounts for more than one-quarter of Bahrain's tourism
receipts, and more than five percent of its manufactured
goods exports. With Saudi oil determining the GOB's
operating budget, oil-derived investment funds driving the
Bahraini real estate and financial markets, and Saudi cash
being spent directly on the local service economy, movements
in Bahraini inflation are likely to be highly correlated to
those in Saudi Arabia. According to the Saudi Arabian
Monetary Authority, inflation there is expected to exceed 10%
in 2008.

Comment
--------------

8. (SBU) The diversification of Bahrain's economy away from
petroleum has only partially insulated it from the
inflationary pressures that the run up in oil has produced.
The CBB's decision to not sterilize foreign assets, combined
with growing social pressure to spend a larger portion of the
oil-price windfall on domestic programs is putting stronger
than expected upward pressure on inflation. As long as the
economy of Bahrain is linked to Saudi Arabia, it will share
in the benefits and trials that a volatile oil market may
bring.

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