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Bahrain’s offshore banking center: The impressive growth of this center and its effects on the region

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1980
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A. S. Gerakis and O. Roncesvalles

In October 1975 the Bahraini authorities invited international banks to establish offshore banks in their country. (These banks, also referred to as offshore banking units, were authorized to do business abroad but restricted in their transactions with the domestic economy for reasons explained later in this article.) The response exceeded the most optimistic expectations. Within four months, 32 applications had been approved, all from multinational banks with the highest standing. At the latest count, this number had gone up to 53; indeed, it appeared that a temporary saturation point had been reached and the authorities were debating whether additional licenses should be issued. As indicated in the table, by the end of 1978 the assets of these banks had risen to US$23 billion, to make Bahrain the second largest offshore center in the developing world after Singapore, where the corresponding total was US$27billion. (This ranking does not take into account the much bigger asset total of the Bahamas, a “paper” center serving as a location of record rather than a place in which banking transactions are actually carried out.) The growth of Bahrain’s offshore banking slowed down in 1979 due to political difficulties in the Gulf area, but it has been on the whole remarkable.

Bahrain proved attractive to the international banks for several reasons. First, after the increases in oil prices in 1973 and 1974, a number of countries in the area were accumulating massive balance of payments (BOP) surpluses and the banks hoped they would be able to tap this money. Second, working conditions in Bahrain were satisfactory. Local transportation and communications facilities, as well as the supply of skilled labor, were adequate; moreover, after an initial period of shortages, the supply of office space and housing increased considerably and rents declined to reasonable levels. Few, if any, rules were applied to limit private enterprise and, in particular, foreign exchange and trade transactions were entirely free of restrictions. Regulatory and fiscal incentives were provided: offshore banks were exempted from the obligations to maintain reserves with the central bank and to observe liquidity ratios; no withholding tax was applied on the interest income of depositors; and no income tax is levied in Bahrain.

A third factor favorable to the development of Bahrain as a financial center resulted from its time zone. A large part of its business day, which extends from the closing of the workday in Tokyo to the opening in New York, coincides with office hours in London and Western Europe.

Geographical distribution of the assets and liabilities of offshore banking units in Bahrain(In millions of U.S. dollars)
1976197719781979
Dec.Dec.MarchJuneSept.Dec.MarchJune
Assets
Arab countries2,4877,0658,2169,66310,67211,68812,28812,953
North America13468110171136277209353
Western Europe1,1293,9044,1904,9905,5255,3014,4264,852
Other offshore centers11,2411,8881,9812,3652,3992,9712,2681,739
Other1,3442,3763,0773,0363,4383,2043,0773,576
Assets = Liabilities6,21415,70117,57420,22522,17123,44122,26823,473
Liabilities
Arab countries2,5788,2559,50311,06312,20911,66612,05112,902
North America2144199961,9541,6271,8911,2821,290
Western Europe2,2774,9955,1664,9135,8327,0186,3146,840
Other offshore centers19231,5391,2761,0391,3921,8501,4791,488
Other2224936331,2561,1111,0161,142953
Source: Bahrain Monetary Agency.

Bahamas, Hong Kong, Singapore, and Lebanon.

Source: Bahrain Monetary Agency.

Bahamas, Hong Kong, Singapore, and Lebanon.

Transactions are thus facilitated with these areas. Furthermore, transactions between parties in Bahrain and the surrounding region can be based on rates prevailing at the same time in the major international markets; uncertainties on this score are thereby eliminated. There is also the convenience of an overlap with the business day in Singapore’s market in which the offshore banks of Bahrain purchase and sell Asian currencies.

Finally, while the demand for banking services had increased in the Middle East, there was no serious competition from other cities in the area. Beirut had declined as a banking center, owing to Lebanon’s internal troubles. Amman had stated an intention of developing a center, but never tried hard to do so; the Jordanians did not really need to diversify their economy in this way, given that their BOP was strong and that they had attained full employment. Kuwait had developed along different lines, as the Middle East’s long-term capital market. The United Arab Emirates had made a bid to become an offshore center, but it proved abortive owing to political, economic, and banking difficulties.

Reflecting the above advantages, the offshore banks have done well in Bahrain. It has been reported that on the average they have realized profits of US$1 million annually on a balance sheet of US$450 million and expenditures of US$1 million per annum. Their operations are said to have become profitable after a stay of only 12 months or even less. Encouraged by this experience, the banks have hired more staff and are otherwise expanding their activities.

Impact on Bahrain

Bahrain is a small country with a population of 340,000 (including immigrant workers) and a gross national product (GNP) of US$1.5 billion, of which net oil exports account for about 70 per cent. It was first in its geographical area to produce oil, but it is also likely to be among the first whose production will run out, indeed in the not too distant future. That is why the Bahrainis attach considerable importance to diversifying their economy. Among other things, they have taken the necessary steps to modernize agricultural production, have built some large industrial plants, and are now trying to develop related light industries. However, given the paucity of its natural resources, Bahrain’s future does not seem to lie in the commodity sectors.

For this reason, the country has set for itself the goal of becoming one of the major service centers in the Middle East. It is therefore striving to maintain its position as a gold market and transportation hub of the region. The authorities are building hotels and otherwise trying to attract tourism. Furthermore, legislation has been passed for the purpose of encouraging foreign companies to establish their regional headquarters in Bahrain. With the same objectives in mind, the Bahrainis are working to develop money, capital, and exchange markets. They have brought in six internationally known foreign exchange and money brokers, have licensed four investment banks, and have approved several issues of securities, including government bonds and promissory notes of the existing Bahraini aluminum company. Thought was given to starting a local stock market, but the idea was abandoned as impractical in view of the small size of the domestic company sector in Bahrain and of the experience in Kuwait, where a sharp decline in share prices toward the end of 1977 forced the authorities to support the market on a large scale.

The offshore banking center is, of course, one of the most important elements in the diversification plans of the Bahraini authorities, and its impact on the economy has already been substantial. The Bahrain Monetary Agency estimates that the country’s gross foreign exchange receipts from the center are equal to US$50 million, or to 13 per cent of non-oil exports and 4 per cent of non-oil imports. These receipts consist of salaries of the local staff, rent paid for office and residential accommodation, payments of the municipal tax on rents, employer contributions to the social insurance scheme, charges for the use of telecommunications facilities, and the annual license fee of US$25,000 levied on each bank. As regards the contribution of the offshore banks to national income, it is reported to be of the order of US$80 million, or 5 per cent of GNP. Parallel to the direct benefits from the activities of the offshore banks, there are several indirect effects, such as the on-the-job training received by their local employees, and the stimulus their operations have provided to tourism through visits by foreign businessmen, customers of the banks, and bankers attending the numerous conferences given for them in Bahrain.

In establishing its offshore center, the country has not only reaped benefits but has also incurred costs. For instance, the expenditures to build up the communications and transportation facilities and to create the machinery for the supervision of the banks should be properly considered as attributable to the center in whole or in part. Although relevant statistics are not available, these costs appear to be much less than the corresponding gains.

Regional impact

The offshore banking units have helped to improve banking and exchange market conditions in their region, but, on the other hand, they have also been accused of causing friction between Bahrain and neighboring countries. About 55 per cent of the offshore banks’ business represents deposits mainly from banks in Gulf states and loans to governments and transnational companies in the wider Middle Eastern area; as a result there has been a sizable recycling of funds from the surplus Arab nations to those incurring BOP deficits. The banks give short-term credits for imports and exports, issue letters of credit, and arrange for performance and other bonds needed in connection with bids or contracts in Middle East countries, particularly Saudi Arabia and Kuwait. In the field of medium-term and long-term finance, they have participated in bond issues—some denominated in Gulf currencies, including Bahraini dinars. It should be mentioned in this connection that the authorities of Bahrain wanted to see their currency used in the bond markets, partly for reasons of prestige. They hoped that the dinar would, in fact, prove attractive in the role of such an international unit of account as a compromise between a strong currency with a low interest rate and a weak one bearing a high rate of interest.

One of the most noteworthy achievements of the offshore banks is that they established money and interbank markets in Bahrain, linking their counterparts throughout the Gulf area. This made it possible for, say, a Saudi Arabian bank to deposit funds in Bahrain, if interest rates were higher there, or borrow if they were lower. Interest rate differentials have therefore diminished in the region. Furthermore, owing to the increased banking competition introduced by the offshore banking units, spreads between deposit rates (bid and offer) have narrowed considerably and are presently in line with margins in international markets. There has similarly been a decrease in the spreads between deposit and lending rates.

In addition to money market operations, the offshore banks have been active in spot exchange transactions and are increasingly satisfying the commercial demands of the Gulf area, especially for non-dollar currencies paid for by the holders in dollars purchased from central banks. As noted earlier, there is also some trading in Asian currencies. A unique feature of Bahrain’s foreign exchange market, indicative perhaps of a large volume of transactions, is that trading is now possible every day of the week, including Saturdays and Sundays. According to an estimate published in Euromoney (April 1979, pp. 14-15), the daily turnover in Bahrain’s foreign exchange market is US$2 billion, about as much as in Singapore and Tokyo. The same source estimated the turnover in London as US$50 billion, in New York as US$40 billion, and in Frankfurt as US$10 billion.

The offshore banking center is further credited with the creation of a much-needed forward market for Middle Eastern currencies, particularly Saudi Arabian riyals and Kuwaiti dinars. The supply of exchange in this market has come largely from German, Japanese, and Swiss contractors paid in local currency as required by existing Saudi Arabian and Kuwaiti regulations. In addition, since October 1977—given the policy of the Saudi Arabian authorities to maintain their exchange rate close to their declared parity in terms of the special drawing right (SDR) and, therefore, to move it frequently vis-à-vis the U.S. dollar—there have been substantial sales and purchases of Saudi Arabian riyals against dollars by both contractors and speculators. As is normally the case in exchange markets, forward rates reflect interest rate differentials. For example, if in the offshore market the three-month deposit rate for Eurodollars is 10 per cent per annum and for Saudi Arabian riyals is 5 per cent, there would be a premium of 5 per cent per annum on the three-month forward riyal.

Forward facilities are still not available on any significant scale in the Gulf countries around Bahrain. There, interested parties cover themselves by using the familiar combinations of spot exchange and money market transactions. For example, a Swiss contractor due to receive Saudi Arabian riyals one year from today will borrow riyals, buy Swiss francs spot, and use the scheduled riyal receipts to repay his loan. Hedgers are thus given a choice. When interest rates on, say, Saudi Arabian riyals are lower in Saudi Arabia than in Bahrain, it pays to borrow riyals in the former country rather than sell riyals in Bahrain’s forward market.

From a very modest beginning, the forward market in Bahrain has grown by leaps and bounds; at the end of December 1978 the outstanding forward purchases (or sales) of the offshore banks amounted to the equivalent of US$3.8 billion. The forward market has, in addition, been able to improve the facilities it offers which are now competitive with those in Western countries. Thus, in Bahrain one can sell or purchase Saudi Arabian riyals forward for periods of up to five years, Kuwaiti dinars for three years, U.A.E. dirhams for 18 months, and other Gulf currencies for 12 months.

Unfavorable aspect

A negative effect of the activities of Bahrain’s offshore banks is that vested interests have been antagonized in a number of the neighboring countries. The existing friction has been widely reported and is admitted, though understandably downplayed, by the Bahraini authorities. Several reasons have been given for these difficulties. According to one explanation, the Saudi Arabians, who are opposed to the internationalization of their currency, are unhappy to see in Bahrain a large pool of riyals outside their borders and beyond their control. Second, fears have been expressed that the lending operations of the offshore banking units undermine economic stability in the Gulf states. Third, it has been asserted that speculation by offshore banks has intensified exchange rate fluctuations and, in particular, that it was responsible for the U.A.E. dirham crisis in early 1977. Last, it is argued that the offshore banking units borrow funds at low rates from the surrounding countries and use these funds, together with aggressive competitive techniques, to take business away from the local banks.

This friction creates problems for Bahrain, complicating its relations with neighboring states, in particular with Saudi Arabia, on which the Bahraini economy heavily depends. There is also a cost from the standpoint of the offshore banking center. The countries which felt that their interests were being hurt have at times obstructed the flow of their currencies to the offshore banks. This has contributed to sharp fluctuations in the short-term rates for deposits, especially the overnight rates. The restrictive measures of Bahrain’s neighbors have usually been implemented indirectly by commercial banks rather than by the monetary authorities. An exception occurred some time ago when Kuwait modified its definition of bank liquid assets so as to exclude from that concept deposits in Kuwaiti dinars with the offshore banks. Thus, Kuwaiti banks not satisfying their liquidity ratio were forced to repatriate dinar deposits from Bahrain.

Policy issues

The above analysis shows that Bahrain’s offshore banking center has done quite well in several ways. In less than five years, it has attracted the elite of the multinational banks, has grown at an exceptional rate, and has provided extensive financial services. For the Eurocurrency market as a whole, it has supplied a missing geographical link in a time zone and location bordering on the surplus oil producing countries. The Gulf region has benefited from the increased competition among banks, which has led to improved conditions in the area’s money, capital, and foreign exchange markets. Bahrain itself has profited, since it has gained a new source of income of significant proportions, given the dimensions of its economy.

A note of caution should be sounded here. Other countries wondering whether it would be worthwhile to try to become offshore banking centers should bear in mind that Bahrain’s commendable performance was initially due to a unique set of circumstances. First, a number of fortuitous events created an ideal opportunity for Bahrain. These included the substantial increase in the demand for banking services associated with the accumulation of oil wealth after 1973, as well as the lack of competition from any other financial capital in the region. Second, Bahrain had the leadership and expertise in the banking field to capitalize on these developments. Under this leadership the Bahrain Monetary Agency not only took the imaginative step of going ahead but subsequently also ran the center effectively, paying due attention to the attitudes of the foreign bankers and local sensitivities.

At the present time, despite the temporary slowdown in the growth of the offshore banks, the situation continues to be favorable and the outlook is for considerable further expansion. Bahrain has already developed the necessary administrative machinery; its position has become entrenched because it has achieved economies of scale. As a result, the establishment of competitive centers nearby will be very difficult, if not impossible. Moreover, the country is likely to benefit from rises in oil prices.

In discussing the advantages and disadvantages of an offshore center, some observers have expressed fears that the foreign banks might extend loans on too large a scale and thus generate inflationary pressures in the countries where they are located or in neighboring ones. There is no evidence that the Bahraini banks’ operations actually did so. One guarantee against destabilizing activities is the quality of the offshore banks, which, as already noted, belong to the group of major international banking institutions. Another safeguard is that, once in Bahrain, the banks (as well as their branches elsewhere) have strong incentives to conform to the wishes of the authorities and to the moral suasion exercised by the Bahrain Monetary Agency. Nevertheless, reflecting official uneasiness regarding the possibility of excessive lending inside the country, various limitations have been imposed on transactions of the offshore banks with residents. In the opinion of the writers, the case for such limitations appears weak, given that Bahrain does not maintain restrictions on capital movements so that Bahrainis can borrow freely from any bank abroad. On the other hand, the restrictions which seek to prevent the offshore banking units from doing retail business with private customers in Bahrain appear justified. The domestic economy is adequately serviced by the 19 existing commercial banks, which include some of the biggest multinationals.

The performance of Bahrain’s offshore banks has been marred only by the friction which has emerged because they have introduced aggressive competitive practices in certain other Gulf states, particularly in Kuwait and Saudi Arabia. Yet this should not be a very serious difficulty. The offshore banking units are said to have captured about 5 per cent of the business of banks in the neighboring countries. For a problem of such small dimensions, remedial measures could be easily devised, especially if it is agreed, as it should be, that Bahrain’s offshore center is performing a useful task for all the parties concerned. Among other things, moral suasion by the Bahrain Monetary Agency should be able to play an effective part in restraining the activities of the offshore banks in the surrounding areas.

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