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. 
 
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HENZEL