Bahrain - Managing a nonrenewable resource : savings and exchange-rate policies

Bahrain's oil-producing economy is vulnerable to terms-of-trade shocks for oil in the short to medium run. But the country's dependence on nonrenewable hydrocarbon resources represents a more basic constraint on Bahrain's prospects for long-term economic growth and welfare. To maintain economic growth and welfare in the post-oil era, Bahrain must save more of its oil revenues and assets and use them to invest abroad and to support economic diversification. The authors derive optimum domestic savings rates for Bahrain in the context of a two-assets (oil and non-oil) intertemporal welfare-maximizing model. Based on these derived rates, they recommend that the current suboptimal savings ratios be raised by about 10 percent of GDP. Achieving such a high savings rate is probably not economically feasible or politically sustainable in a stagnant economy, because it implies significantly reducing absolute levels of real consumption. Such austerity would not be necessary in a growing, efficiently restructured, and diversified economy, in which the real exchange rate policy played a key role by stimulating non-oil tradable sectors that could replace oil when it dries out. But the success of real exchange rate depreciation itself depends on a sufficiently high savings rate, to free up resources to switch to the production of other tradables. The authors present an empirical three-sector model of the real exchange rate, which permits links between the equilibrium real exchange rate and the optimum savings rate. They use this model to compute what real depreciation is required consistent with the derived optimum savings ratios. Their model predicts that a real depreciation of about 31 percent would be needed between 1992 and 2005 to avert serious overvaluation over this period.