Bahrain is rated Baa1/BBB/BBB, stable outlook, the lowest of the oil exporting sovereigns in the Gulf Cooperation Council (GCC) countries. Regionally, it is rated on par with Morocco, although the latter has a negative ratings outlook given wider fiscal deficits and large current account deficits (versus double digit surpluses in Bahrain). Beyond the region, rating comparables could include commodity driven BBBs such as Brazil, South Africa, Russia, Indonesia but these are significantly larger, more diverse and hence stronger economies. Given where these comparables trade, the Bahraini curve offers a good pick-up.

Bahrain’s credit profile is supported by two principal strengths. First is its natural resource endowment, principally of hydrocarbons. However, given that Bahrain is the oldest oil producer in the GCC, current estimates of oil reserves are low (125 million barrels; EIA) with more than 80% of current crude output (200kbpd; IMF) from an oil field shared with Saudi Arabia; Bahrain’s own oil production is from the onshore Awali oilfield where production is thought to have peaked in the 1970s. Bahrain is however trying to further develop its oil sector, including through the use of enhanced oil recovery techniques, increasing refining capacity (with Saudi crude as feedstock), offshore exploration and new onshore wells. This should help raise production in the near term, which will be supportive for fiscal accounts. Be that as it may and leaving aside the relatively small life of crude reserves, Bahrain continues to record double digit surpluses in the external sector, this year and (as per IMF projections) at least through till 2015.

The second key underpinning for the sovereign is external support, particularly from regional GCC countries and the West. As highlighted above (shared oil field), Bahrain’s enjoys a close relationship with Saudi Arabia – there has even been talk of a closer union between the two countries – highlighted in the lead role Saudi forces took in the GCC’s Peninsula Shield which helped clear the streets of Manama in the aftermath of post pro-democracy protests starting in February 2011. Further, the GCC-4 (Saudi Arabia, Qatar, Kuwait and the UAE) have also announced a USD10 billion 10 year financial aid package that will be used for off budget infrastructure spending. In terms of the West, the US continues to maintain a large military presence in the country – Bahrain is home to the Fifth US Naval Fleet. Broadly speaking, this support is a reflection of Bahrain’s geopolitical significance – the island is located off the coast from the Saudi eastern province, home to much of Saudi crude and the country’s Shia minority. In the current charged sectarian environment in the region, Bahrain’s significance is probably even higher. We thus expect this support factor to sustain in the future. Taking this into account, Bahrain thus offers a significant pick-up even on Saudi corporate names.

On the negatives front, a small natural resource endowment and the reliance of public finances on hydrocarbon revenues has meant that Bahrain’s fiscal dynamics are quite weak. It is the only GCC country expected to record budget deficits this year and next, in line with outcomes post global financial crisis. And although the deficits are modest (Fitch expects them to average around 3% this year and next), public debt levels have risen quite sharply since 2008: from 14% of GDP, the general government debt ratio is expected to cross 40% of GDP this year. Also highlighting Bahrain’s fiscal weakness is its budget breakeven price, which stands at just under USD120/bbl for 2013, higher than other GCC countries and Iraq. In the medium term, support from higher production and off budget spending financed by the GCC aid package may help prevent a continuous worsening in public debt ratios.

There is also some concern around the offshore banking system, wherein the balance sheet has fallen consistently since the global financial crisis, contracting by ~40%. Hence, as Fitch notes, the financial sector (15% of GDP) is not likely to be a major growth driver going forward. The sector though is well capitalized and enjoys strong proven support from MENA based parent companies/institutions.

Third, as we noted yesterday, tourism/services have also been hit due to political unrest since February 2011 – the cancellation of the Bahrain Grand Prix that year and the controversy surrounding the event in 2012 and 2013 is one example. There are also worries surrounding weekend traffic from Saudi Arabia since the pro-democracy movement. This traffic brought some 9.5 million Saudis in 2010; in the first half of 2011, the latest data available, this had fallen to about 3 million, meaning a 37% decline year on year.

Finally, political unrest continues in Bahrain, with not much clarity on how the situation will be resolved. Bahrain is a Sunni monarchy while the population is majority Shia. Protests in the capital Manama have not been as significant as was the case in early 2011, reflecting the government’s tough security response. However, protests do appear to be a regular feature outside the capital. Our concern is that if government efforts to find a solution do not bear fruit, this could push Shia activists towards more radical tactics. Domestically, the powers that be appear split on whether to use strong arm tactics, or give into some of the protester demands. A carrot and stick approach though does not seem to be working, as may actually be helping marginalize mainstream Shia political forces, pushing protesters to groups with more hawkish demands. All said, we do not expect significant progress on the issue in the near term.