Bahrain's economy is characterized by producer and consumer subsidies and, possibly misaligned currency. These subsidies have resulted in lower savings rates than would be consistent with the country's endowment in oil and gas. In addition, the misaligned real exchange rate has encouraged imports, at the same time creating incentives biased against the non-oil tradable sectors. So, Bahrain's economy remains largely dependent on a rapidly depleting hydrocarbon resource base. The authors espouse a macroeconomic consistency framework to focus on the behavior of Bahrain's economy along two paths. Part one is based on the assumption that the government's present macroeconomic policy will continue. In that case, the solution exhibits bubbles - fiscal and current account imbalances that would be unsustainable over time. Meanwhile, real appreciation of the dinar would suppress non-oil exports. As a result, the need for foreign borrowing would be more pressing. In an attempt to restore the equilibrium, the government would need to contain aggregate demand by compressing imports and investment, thereby worsening the economic situation. Path two is based on a reform strategy that includes policies to raise the domestic savings rate, improve the fiscal situation (by rationalizing expenditures and introducing income taxes and cost recovery measures), and correct the misaligned exchange rate. The results show that the expenditure-switching effect of the exchange rate alignment would shift resources in favor of the tradable sectors. Non-oil GDP and exports would register high growth rates while economic diversification, in the context of a growing and more dynamic economy, would foster investment efficiency. This would help Bahrainis maintain a high standard of living as the oil income dries up, without too much loss of consumption for the present generation.
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