DUBAI: Capital flight from Bahrain is starting to pressure its currency and threaten its position as a Gulf financial center, though it looks likely to avoid a full-blown currency crisis for now. The small non-OPEC oil producer, where nearly $10 billion in mutual funds was parked last year, is the first Arab banking hub to be hit directly by the political instability sweeping across the Middle East and North Africa. It is struggling to contain its worst unrest since the 1990s after majority Shia protesters took to the streets, prompting Saudi Arabia to send in troops in an effort to restore order. As many as six people were killed on Wednesday. The central bank's tight control over the foreign exchange market, and the possibility of other Gulf countries providing financial support to prevent market turmoil from spreading, mean Bahrain is unlikely for the foreseeable future to have to abandon the dinar's peg against the US dollar. "A normal reaction to the ongoing downgrades by credit rating agencies would be outflow of short-term capital from the country, but different from other examples, possible financial helplines from other GCC (Gulf Cooperation Council) countries are an alleviating factor," said Kubilay Ozturk, EMEA economist at Deutsche Bank in London. But bankers said there had been substantial outflows of funds from Bahrain this week. On Wednesday, banks in Manama's financial district closed down, the central bank operated from an alternate location and the stock market stopped trading. Downgrades Bahrain, home to a $66 billion Islamic finance industry, has faced several downgrades by debt rating agencies since protests started in February, and the cost of insuring its sovereign debt has hit 20-month highs. Fitch Ratings on Tuesday slashed its sovereign credit rating of Bahrain, which has postponed a $1 billion government bond issue, by two notches to BBB, citing political risks. The scale of capital outflows from the smallest Gulf economy of 1.2 million people is hard to estimate because of a lack of timely data. The experience of Egypt is modestly encouraging for Bahrain; when commercial banks reopened in Egypt in February after political unrest, the central bank was prepared for an immediate outflow of $8-10 billion from Egyptian pounds, but only about $1.7 billion was transferred out on the first day and about $1 billion on each of the next two days. But anecdotal evidence suggest substantial sums have already been moved out of Bahrain, whose banks hold assets of about $200 billion. One banking source, speaking on condition of anonymity, estimated 15 to 20 percent of deposits and investments of high-level Bahraini citizens in private banks had been withdrawn over the past few days. "A lot of clients are pulling out their money, they're moving it to London, Europe, wherever. It's not a question of taxes, but of access to their money," another banker from the region said. "One client pulled out $30 million in a matter of days. With banks closed, movements are limited — we will see the rush when they reopen." While nearby Qatar and the United Arab Emirates could receive the fund flows, as they have so far escaped political protests and have small local populations pampered by petrodollars, some bankers said they would just be temporary stops for the funds. "In at least two or three banks, the bulk of the clients have shifted their money abroad," a banker said. "Some are moving it through the Emirates, then on to other centers. It makes the transaction less remarkable, as moving a big chunk of money from Bahrain to, say, London would raise eyebrows in this climate." Should the political crisis drag on, even long-term investors may start to consider relocating their capital, seriously undermining Bahrain's status as a financial hub where foreign claims on banks amount to 92 percent of gross domestic product. "The type of money Bahrain was receiving is long-term money," said John Sfakianakis, chief economist at Banque Saudi Fransi. "If uncertainty continues over several months and people take out a lot of money, it will have a deep negative impact." Currency The dinar briefly weakened away from the 0.376 peg to the dollar on Wednesday, dropping as far as 0.37716, but it soon bounced back as the central bank intervened to supply dollars. Although the central bank had net foreign assets of just $4.7 billion at the end of October 2010, many analysts said its reserves would be enough to see off any threat to the peg, especially because the peg system helps the central bank to influence trade. "We do not expect pegs to be broken. It would create a bit of precedent in the region and many central banks and authorities across the GCC have been priding themselves on keeping the pegs unchanged," said Bartosz Pawlowski, head of strategy for the region at BNP Paribas in London. "In order to have a pressure on the peg you need to have a really functioning market. The risks as we stand are minimum." If necessary, Saudia Arabia might use its resources to defend Bahrain financially, just as it is physically deploying its troops, analysts said. "Bahrain has foreign reserve resources to support the currency and at the very end of the day even if there were pressures, Saudi Arabia and GCC would likely alleviate pressure through further financial assistance," said Farouk Soussa, Middle East chief economist at Citi in Dubai. Bahrain, which needs crude oil prices as high as $97 per barrel to be able to balance its budget, is set to receive $10 billion from its wealthier Gulf neighbors to upgrade housing and infrastructure over 10 years. However, a tumble by the Bahraini dinar in the forwards market on Wednesday suggested what might happen to the currency if authorities did not maintain consistent support. The forwards briefly implied dinar depreciation of about 0.9 percent in one year's time, before they bounced back in response to the central bank intervention. –Additional reporting by Martin De Sa'Pinto in Zurich and Frederik Richter in Manama
