Bahrain's economy is rebounding on the back of heavy government spending and support from its neighbours, but a full recovery may be out of reach if anti-government protests continue.
A year after mostly Shi'ite demonstrators launched protests against Bahrain's Sunni Muslim rulers, demanding an end to sectarian discrimination and more say in government, authorities are seeking to quell discontent by doling out benefits to citizens: higher salaries, housing and better infrastructure.
But the spending has had only limited success in reviving the island kingdom's reputation as a regional banking, trading and Islamic finance hub, as unrest continues on the outskirts of the capital Manama.
The damage to the economy is somewhat permanent, said Michael Stephens, researcher at the Doha-based Royal United Services Institute for Defence and Security Studies.
Bahrain has been a financial hub and has all legislations in place for businesses. However, political instability continues and this is unlikely to change anytime soon. I don't think the government can encourage business in Manama without solving the political situation.
Economic conditions in Bahrain have improved considerably since the first quarter of 2011, when gross domestic product shrank 1.3 percent because of street violence that temporarily closed businesses and prompted the evacuation of foreigners. GDP grew 2.2 percent quarter-on-quarter between July and September, the most recent period for which data is available.
But politics continue to overhang the economy of 1.3 million people. The Bahrain Air Show in January, the first big international event since the unrest, was marred by protesters who tried to disrupt it by burning tyres and organising rallies.
More protests are expected before the Bahrain Formula One Championship in April, which the government hopes will show a climate of normalcy. Another possible focus of opposition activity is February 14, the first anniversary of the uprising.
The latest GDP data underlined how political uncertainty is distorting the economy. The output of the oil and gas sector climbed an inflation-adjusted 3.5 percent from a year earlier in the third quarter on the back of high oil prices. But the real estate sector was down 5.6 percent, as investors stayed cautious, and the hotel and restaurant sector fell 8.7 percent, suggesting business travel and tourism continued to suffer.
Most of the real economy was still in contraction by the third quarter of 2011, said Nancy Fahim, a Standard Chartered economist. While recovery is taking place, sporadic political events in 2012 are possible and would present downside risks to growth.
The government says Bahrain continues to attract new foreign investment; in December the central bank said it had granted in-principle approvals for two Geneva-based investment houses and a foreign reinsurance company to set up offices in the country.
But there is also anecdotal evidence of some investors pulling out of Bahrain. French bank Credit Agricole intends to shift its regional headquarters from Bahrain to Dubai, sources familiar with the matter said in August; one source said the company might keep a small office in Bahrain but that most staff and operations would be moved. The sources declined to be named because of the sensitivity of the issue, while Credit Agricole declined to comment.
Total foreign liabilities of Bahrain's banking system, which include deposits by foreign customers in Bahraini banks, fell to $148.3 billion (93.6 billion pounds) in the third quarter of last year from $151.6 billion in the previous quarter and $168.0 billion a year earlier, central bank data shows.
Coupled with the deleveraging in global banks, problems with some wholesale banks and the impact of the domestic political situation will mean that the financial sector in Bahrain will not be able to contribute to headline growth as strongly as it has in the past, RBS economist Raza Agha wrote in a research report.
A Manama-based businessman who deals in transport services said some of his friends were shutting down their businesses and leaving the country after spending years there.
Things are not the same...they will never be the same, said the Bahraini, who is of Sunni origin but did not want to be named because of the political sensitivity of his remarks. We are always worried about what can happen next.
Bahrain, the only Gulf country to experience large-scale, violent protests during the Arab Spring, also faces a challenge in the form of a widening of the government's budget deficit because of increased state spending on benefits for citizens.
The spending surge boosted the oil price which Bahrain needs to balance its budget to $114 per barrel in 2011 from $51 in 2006, Citi analyst Farouk Soussa calculated. A Reuters poll of analysts, conducted in December, predicted Bahrain would run a deficit of 5.0 percent of GDP this year after an estimated 2.8 percent in 2011.
Bahrain is growing more vulnerable to oil-price shocks, given higher break-even oil prices required for the government budget, Fahim said.
Rich Gulf countries have pledged $10 billion of aid to Bahrain over coming years to help it cope with the unrest. Shaikh Mohammed bin Essa Al-Khalifa, chief executive of Bahrain Economic Development Board, told Reuters that the money would assist key development projects in priority areas such as housing and infrastructure.
Many analysts also expect Saudi Arabia to step in with additional aid for Bahrain if that is necessary to solve budget problems, given the importance of the island's stability to the region.
The state will continue relying on subsidies from Saudi Arabia for growth in 2012. Other measures may be insufficient amid the continuing political instability, RUSI's Stephens said.
But the prospect of more Saudi support and the return of economic growth have not brought down the cost of insuring Bahrain's sovereign debt against default; its five-year credit default swaps traded around 400 basis points this week, near two-year highs and in the same area as Dubai, which has been hit by concern about the debt burdens of its corporations.
In November, Bahrain's finance minister estimated GDP would grow between 1.6 and 1.7 percent in 2011 as a whole, accelerating to 4.5 percent in 2012. That would return the island to the kind of growth rate which prevailed before the uprising. The Reuters poll of economists, however, predicted growth this year of just 3.0 percent.
(Editing by Andrew Torchia)