OREANDA-NEWS. Fitch Ratings has downgraded Bahrain's Long-Term Foreign Currency Issuer Default Rating (IDR) to 'BB+' from 'BBB-' and Long-Term local currency IDR to 'BB+' from 'BBB'. The Outlooks are Stable. The issue ratings on Bahrain's senior unsecured Foreign and Local Currency bonds have also been downgraded to 'BB+' from 'BBB-' and 'BBB', respectively. The Country Ceiling has been affirmed at 'BBB+' and the Short-Term Foreign Currency IDR has been downgraded to 'B' from 'F3'.

KEY RATING DRIVERS

The downgrade of Bahrain's IDRs reflects the following key rating drivers:-

Lower oil prices are causing a marked deterioration in Bahrain's fiscal position. There is progress in fiscal consolidation, but not a clear path towards reaching a more sustainable position. Fitch expects general government debt to rise to nearly 80% of GDP in 2016 from around 62% of GDP in 2015, well above the 'BBB' and 'BB' medians of around 40%. Debt service is an increasing burden on the state budget and Fitch expects it to rise to around 41% of revenue in 2016 and 55% in 2017, from 30% in 2015. Interest payments will be around 20% of budget revenue in 2016-2018. Debt issuance costs have risen.

Fitch expects the general government budget deficit to widen to 15.4% of GDP in 2016, from 14.8% of GDP in 2015, under a baseline Brent oil price assumption of USD35/bbl for 2016 (rising to USD55/bbl in 2018). Fitch estimates that Bahrain's fiscal break-even Brent oil price is around USD130/bbl. The deficit is more than three times the 'BBB' and 'BB' medians. Oil and gas receipts (historically around 85% of budget revenues) fell approximately 40% in 2015 and Fitch expects them to fall a further 20% in 2016. Fitch's forecast for 2016 assumes steady progress towards implementation of the government's revenue and cost-cutting initiatives, with non-oil revenue rising and expenditure falling.

The policy response has been insufficient to significantly ease the unfavourable fiscal and oil price dynamics. According to Ministry of Finance calculations, revenue measures with a full-year fiscal impact of around 1% of GDP have already been implemented in 2015 and early 2016 and measures worth a further 1% of GDP are planned. Subsidy reduction measures could eventually generate savings of more than 5% of GDP per year. Implementation of a 5% rate of VAT in 2018, if agreed, could yield up to 1.6% of GDP in revenue, according to IMF calculations. Even assuming full implementation of these measures and a Brent oil price of USD55/bbl, the general government deficit would still be 7.3% of GDP in 2018. More measures to reduce current expenditure are in the pipeline but have not yet been quantified.

Bahrain's IDRs also reflect the following key rating drivers:-

Fitch expects real non-oil growth to remain steady at 4% in 2016-2018 as increased activity associated with state owned enterprise investments and GCC Development Fund projects offsets the dampening effect on demand of tighter fiscal policy. Non-oil growth is also supported by macroeconomic stability, a strong local skills base, a cost advantage and a relatively well-developed environment for doing business, particularly in the financial sector. In conjunction with expected oil sector growth of around 0.5%, this will result in overall real GDP growth of around 3.3% in 2016-2018. Real GDP expanded by 2.9% in 2015, with hydrocarbons sector contracting by 0.9% and output in the non-oil sector rising by 3.9%.

A strong banking sector supports the rating. Banks are well-placed to extend more credit to the economy and the government, enjoying profitability, high levels of capitalisation and liquidity, and low non-performing loan levels. Wholesale banks' foreign assets support Bahrain's net external creditor position (46% of GDP), well above that of the median 'BB' country. Higher policy rates and yields on government bonds have not translated into higher private sector borrowing costs, with many domestic entities being able to borrow below the sovereign curve.

Governance indicators as measured by the World Bank are stronger than the 'BB' medians, despite Political Stability and Voice and Accountability scores that are worse than for 85% of all countries rated by Fitch. Tensions continue between the government and the predominantly Shia opposition and sporadic low-level violence continues. Social pressures and the lack of a sustainable political solution hamper implementation of the fiscal reforms necessary to tackle the worsening debt trajectory.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Bahrain a score equivalent to a rating of 'BBB-' on the Long-Term FC IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- External Finances: +1 notch, to reflect Bahrain's large net external creditor position.

- Public Finances: -2 notches, to reflect a rapidly worsening fiscal position and rigidities in the government revenue and expenditure profiles.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The main factors that could lead to negative rating action are:

- Failure to reduce the fiscal deficit sufficient to stabilise the government debt-to-GDP ratio.

- Severe deterioration of the domestic security situation.

The main factors that could lead to positive rating action are:

- A reduction in the budget deficit consistent with a decline of the government debt-to-GDP ratio in the medium term.

- A broadly accepted political solution to domestic political tensions.

KEY ASSUMPTIONS

Fitch assumes that Brent crude will average USD35/bbl in 2016, USD45/bbl in 2017 and USD55/bbl in 2018.

Fitch assumes that Bahrain will continue to derive fiscal savings and growth support from the implementation of GCC development projects financed by Kuwait, Saudi Arabia, and the UAE. Lower oil prices are not assumed to impact the flow of funds from these countries.

Fitch assumes no change to the rule of the royal family and the current order of succession.

Fitch assumes that regional conflicts will not directly impact Bahrain or its ability to trade.

Fitch assumes no change to the peg of the Bahraini dinar to the US dollar.