VZCZCXRO2517
PP RUEHDE RUEHDIR
DE RUEHMK #0521/01 2171002
ZNR UUUUU ZZH
P 041002Z AUG 08
FM AMEMBASSY MANAMA
TO RUEHC/SECSTATE WASHDC PRIORITY 8035
INFO RUEHZM/GULF COOPERATION COUNCIL COLLECTIVE
RUEHGB/AMEMBASSY BAGHDAD 0262
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.
********************************************* ******** Visit Embassy Manama's Classified Website:
XXXXXXXXXXXX********************************************* ******** HENZEL