Bahrain, the smallest economy among GCC states, should strengthen its revenue base as part of fiscal consolidation and structural reform framework, while shoring up external financing to protect its currency's peg to the US dollar and bolster international reserves, the IMF said on Monday.
Bahrain's dinar exchange rate that is pegged to the US dollar makes sense as the kingdom has delivered monetary policy credibility and low inflation, the Washington-based organisation said after concluding a consultation with the country. However, the IMF "stressed the importance of discontinuing central bank lending to the government", without mentioning how much the government has borrowed from the central bank to narrow the budget deficit.
To build reserves, Bahrain could gradually raise "interest rate differentials vis a vis the US through the stepped up issuance of government securities" that could also help to discourage capital outflows from the kingdom, the IMF said.
The spread of Bahrain's three-month interbank offered rate over the US dollar London interbank offered rate has already expanded to 113 basis points from 74 bps since the end of 2014, according to Reuters. The IMF did not specify how wide the spread should be.
Bahrain, whose long-term issuer rating was cut by two notches to Ba2 by Moody's Investors Service in July, has faced financial difficulties in the wake of a slump in oil prices over the past three years. The kingdom, which is not a member of Opec, has resorted to external borrowing and is running an austerity campaign to narrow the budget gap.
The IMF said Bahrain's fiscal and external vulnerabilities have increased with persistently low oil prices. It posted a fiscal deficit of 18 per cent of GDP and government debt climbed to 82 per cent of GDP in 2016.
"Additional sizeable and front-loaded fiscal adjustment is urgently needed to restore fiscal sustainability and reduce the large fiscal and external financing needs," the IMF said, adding that sustained efforts will be needed over the medium term to put debt on a downward path.
While setting up a public debt management office is a step in the right direction for Bahrain, the country still requires a "comprehensive fiscal financing and debt management strategy" to mitigate risks, according to the IMF.
The budget deficit is projected to improve to 12.2 per cent of GDP this year, because of relatively higher oil prices and continued reduction in spending. Real GDP growth is expected to slow to 2.3 per cent and 1.6 per cent in 2017 and 2018, respectively, reflecting the ongoing fiscal consolidation and weaker investor sentiment. The current account deficit is estimated to reach over 3.5 per cent of GDP in 2017, and is projected to narrow gradually over the medium term, the IMF said.
The fund recommended a reduction in expenditures including the wage bill along with a further cut in energy subsidies and raising non-oil revenue through levying value added tax.
The IMF has conducted a financial sector assessment programme (FSAP) stress test on Bahraini lenders and said the banks are well positioned to face moderate credit and liquidity shocks, although recapitalisation needs could be significant under a "severe shock scenario".
"The liquidity stress tests suggest that most banks' liquidity positions are relatively robust, but some wholesale banks and foreign branches hold few liquid assets," the IMF said, adding that its board of directors welcomed the central bank's efforts to implement FSAP recommendations, including steps to introduce quantitative liquidity requirements for banks and to develop a macro-prudential framework.
"A clear legal mandate for financial stability, stronger risk based supervision, and enhanced crisis management and resolution framework will also help support the financial sector," according to the IMF.