The Structural Problem
Bahrain spends more than it earns. This has been true, with brief exceptions during oil price spikes, for over a decade. The fiscal deficit is not a cyclical phenomenon driven by temporary revenue shortfalls. It is a structural condition rooted in the mismatch between the kingdom’s spending obligations and its revenue-generating capacity.
Understanding this fiscal dynamic is essential for any investor evaluating Bahrain. The kingdom’s competitive advantages — low costs, regulatory agility, financial services depth — exist within an economy that has not solved its most fundamental fiscal equation. Every investment thesis for Bahrain must account for the risk that the fiscal challenge eventually constrains the government’s ability to maintain the business environment that makes those advantages possible.
Revenue Structure
Bahrain’s government revenue derives from several sources:
Oil revenue: Income from the Abu Saafa field (shared with Saudi Arabia, with revenue allocated to Bahrain), BAPCO refining operations, and the limited domestic oil production. Oil revenue remains the single largest revenue source despite decades of diversification effort.
VAT: Introduced at 5 percent in January 2019 and increased to 10 percent in January 2022. VAT is now a meaningful contributor to non-oil revenue and represents the most significant fiscal reform of the past decade.
Non-oil revenue: Licence fees, government service charges, excise taxes (on tobacco and sugary drinks), and other non-oil sources. These have grown but remain insufficient to cover recurrent spending.
Investment income: Returns on government financial assets and dividends from state-owned enterprises, including Mumtalakat portfolio companies.
The fundamental problem is that total revenue — oil and non-oil combined — consistently falls short of total expenditure. This shortfall must be financed by borrowing or by drawing on fiscal reserves and external support.
Expenditure Structure
Public sector wage bill: Government employment is the primary form of national employment for Bahraini citizens. The wage bill consumes a dominant share of recurrent spending and is structurally rigid — reducing government employment is politically sensitive and risks social instability.
Subsidies and transfers: Despite reform efforts, subsidies on utilities, fuel, and food continue to consume a material portion of the budget. Bahrain has made progress on subsidy reform, but the pace is constrained by the need to maintain social cohesion.
Defence and security: Bahrain hosts the US Naval Forces Central Command (Fifth Fleet) and maintains its own defence establishment. Defence spending is a significant and non-discretionary budget item.
Debt service: Interest payments on accumulated public debt consume a growing share of revenue. As debt levels have risen, debt service has become one of the fastest-growing expenditure categories — creating a circular dynamic where borrowing to cover deficits generates additional borrowing costs.
Capital expenditure: Infrastructure investment, including BAPCO refinery modernisation, transportation, housing, and public services. Capital spending is the most discretionary category and therefore the most vulnerable to fiscal tightening.
Public Debt Trajectory
Bahrain’s public debt has risen from relatively modest levels a decade ago to elevated levels that attract persistent credit rating agency scrutiny. Debt as a percentage of GDP has increased substantially, driven by cumulative fiscal deficits.
The debt is a mix of domestic currency obligations and foreign currency borrowings. Bahrain has accessed international debt markets through sovereign bond and sukuk issuances, paying yields that reflect the kingdom’s credit risk premium relative to wealthier GCC peers.
Debt sustainability: The critical question is whether Bahrain’s debt trajectory is sustainable — meaning, can the kingdom service its debt obligations indefinitely without either defaulting or requiring perpetual external support? The answer depends on the speed and scale of fiscal reform relative to the compounding cost of accumulated debt.
GCC Support
The $10 billion GCC support package committed in 2018 by Saudi Arabia, the UAE, and Kuwait was an explicit acknowledgment that Bahrain’s fiscal challenges had systemic implications for the Gulf. The package provided:
Direct grants: Immediate fiscal support that reduced the need for borrowing.
Subsidised financing: Loans at below-market rates, reducing Bahrain’s interest burden.
Project-linked support: Funding tied to specific infrastructure and development projects.
The support package was conditional on Bahrain implementing fiscal reforms — including VAT introduction and subsidy reduction — creating an accountability mechanism. The package bought time and demonstrated GCC solidarity, but it did not resolve the underlying structural deficit.
Strategic rationale for support: GCC support for Bahrain is not charity. Bahrain hosts the US Fifth Fleet, contributes to regional security architecture, and maintains a financial services sector that serves the broader Gulf. A Bahrain fiscal crisis — or worse, a sovereign default — would damage GCC credibility in international capital markets and create geopolitical instability. Supporting Bahrain is cheaper than managing the consequences of its failure.
Reform Options
Revenue Enhancement
Further VAT increases: The 2022 increase from 5 to 10 percent generated additional revenue. Further increases are possible but risk deterring the business investment that Bahrain depends on for economic growth.
Broadening the tax base: Introducing corporate income tax (currently 0 percent for most businesses) would generate revenue but would eliminate one of Bahrain’s most significant competitive advantages. This is the fiscal reform that would generate the most revenue and inflict the most economic damage.
Non-oil revenue growth: Continued growth in financial services fees, fintech licensing revenue, tourism spending, and government service charges. Incremental but meaningful.
Expenditure Rationalisation
Public sector reform: Reducing the wage bill through attrition, early retirement, and productivity improvements. The most impactful lever but the most politically difficult.
Subsidy elimination: Moving to fully market-based pricing for energy, water, and food. Progress has been made; completion would reduce the deficit but increase the cost of living.
Debt management: Refinancing existing debt at lower rates when market conditions permit. Extending maturities to reduce near-term repayment pressure.
Structural Transformation
Economic growth: If Bahrain can grow its economy faster than its deficit, the debt-to-GDP ratio stabilises or declines. This is the aspirational path — growing out of the problem rather than cutting or taxing out of it. It requires continued diversification success, foreign investment attraction, and private sector job creation.
Credit Rating Implications
Bahrain’s sovereign credit ratings are the lowest in the GCC, reflecting the fiscal deficit, elevated debt, and dependence on GCC support. The ratings remain at the lower end of investment grade — a critical threshold because a downgrade to non-investment grade would trigger forced selling by index-tracking and mandate-constrained institutional investors, increase borrowing costs, and damage Bahrain’s reputation as a financial centre.
Rating agency focus areas:
- Fiscal deficit trajectory and reform implementation pace
- Public debt level and debt service burden
- GCC support commitments and disbursements
- Non-oil GDP growth and economic diversification
- External balance and foreign exchange reserves
Maintaining investment-grade ratings is therefore a strategic imperative for Bahrain, not merely a financial technicality. The kingdom’s business model — as a financial centre, a corporate domicile, and a regulated jurisdiction — depends on the credibility that investment-grade status provides.
What It Means for Investors
Risk pricing: Bahrain sovereign bonds and sukuk trade at a yield premium to Abu Dhabi, Saudi Arabia, and Qatar, reflecting the fiscal risk. This premium represents compensation for the structural challenges described above.
Regulatory environment risk: If Bahrain is forced to introduce corporate income tax to address the fiscal deficit, the kingdom’s zero-tax advantage — a cornerstone of its business attraction model — would be eliminated. Investors and businesses that have chosen Bahrain specifically for its tax-free status should monitor fiscal reform discussions closely.
GCC support conditionality: The continued availability of GCC support provides a backstop against worst-case scenarios. Investors should monitor GCC political dynamics and any signals of reduced willingness to support Bahrain.
Business environment continuity: Despite the fiscal challenges, Bahrain’s regulatory environment — CBB oversight, AAOIFI standards, business formation infrastructure — has remained stable and functional. The fiscal challenge is a macro risk, not an operational one. Businesses operating in Bahrain are not currently affected by the deficit in their daily operations.
Bottom line: Bahrain’s fiscal challenge is real, material, and unresolved. It does not make the kingdom uninvestable — it makes it a jurisdiction where the macro risk must be consciously accepted and priced into investment decisions. Investors who understand the risk and accept the premium are adequately compensated. Investors who ignore it are not.