While artificial intelligence was already promising profound changes in the traditional banking business model, the latest innovation in the technology—generative AI—portends a multisensory revolution in banking services. Indeed, GenAI, with its ability to collect and interpret financial data on a vast scale, could force some of the Arabian Gulf region’s biggest banks to rethink their already costly digital banking strategies.

GenAI’s insatiable appetite for data offers banks in the Gulf Cooperation Council states the prospect of not only a more intimate relationship with customers, but also improved management processes, such as fraud detection and other important back-office functions. Unsurprisingly, banks that are best able to quickly deploy GenAI are looking forward to a return on their bottom line, despite concerns over the human impact of the new tech.

Banks that integrate and scale GenAI could see a 22% to 30% improvement in productivity over the next three years, Accenture estimated in a February report on AI in banking, and up to 600 basis points in revenue growth, and 300 basis points in return on equity. In the US, the giant management consultant found, 73% of time spent by bank employees has a high potential to be impacted by generative AI, some 39% by automation, and 34% by augmentation.

Whether those figures would apply to GCC financial institutions is unknown; what is clear is that the Gulf’s petrodollar revenue and its governments’ ability to lavish significant sums to gain a position in GenAI, makes GCC banks financially well positioned to adopt the latest innovations and capitalize on market demand.

Boosting that scenario are highly positive consumer attitudes in the region toward innovative technology such as mobile commerce and the rapid take-up of digital banking by GCC institutions’ customers that sped the rollout of AI chatbots in customer service.

Major Gulf banks, including Al Rajhi Bank of Saudi Arabia, Qatar National Bank, and National Bank of Kuwait are already using AI to varying degrees. In the United Arab Emirates, Emirates NBD has partnered with management consultants McKinsey and QuantumBlack—the firm’s AI arm—with the latter reportedly involved in the design and early-stage deployment of generative AI use cases.

But with GenAI chatbots now available based on OpenAI’s ChatGPT and Alphabet’s Bard, workers can engage and use the latest AI iterations as digital assistants, transforming the way in which banks do business. New opportunities to drive customer engagement, such as gamification, also promise to increase customer retention.

Whether through automation or augmentation, Accenture expects dramatic results in the back, middle, and front offices,  predicting 25% of all staff will be impacted by both. The UAE is backing AI at the government level, with the minister for AI—a position created in 2017—noting in February that nine banks and nine other financial institutions are using blockchain solutions.

The UAE, which has its own AI university, has taken another technological leap, launching its own open-source, open-access large language model. The latest version, Falcon 2, offers itself as the Gulf’s answer to Google’s and Meta’s GenAI innovations. Falcon 2’s array of applications, and its developer’s claim that it is the only AI model with vision-to-language capabilities, makes it probable GCC banks will want to evaluate a homegrown variant.

Generative AI’s potential to rescript the business of banking implies almost limitless applications. However, having poured millions if not billions into digital banking, GCC banks may hesitate over another round of technology investment expenditure. And there is also the question whether they are nimble enough.

“Banks have been traditionally product-centric,” says Rajesh Saxena, CEO of Retail and Central Banking at Intellect Design Arena, a fintech designer for financial services. “This approach has made large-scale transformations within banks time-consuming, expensive, and risky, not least because the back-end systems and products are all embedded into a monolithic architecture.”

But if the cost base for GCC banks is similar to their international counterparts’—staff compensation at global banks makes up half the cost-base on average, Moody’s Investors Service estimates—they may wish to accelerate GenAI integration. Regardless of the potential upheaval, Saxena thinks the latest innovations could quickly up banks’ compliance programs, where generative AI’s speed and accuracy could contain reputational exposure to issues such as money laundering, etc.

“AI algorithms analyze vast amounts of data to assess credit risk, detect anomalies, and prevent AML fraud,” Saxena notes. That might be particularly relevant to financial institutions in the UAE. Earlier this year, the Paris-based Financial Action Task Force removed the UAE from its “grey list” for deficiencies in money laundering controls, a move that drew criticism from some anti-money laundering analysts.

Many traditional banks’ initial indecisiveness in rolling out AI prompted many analysts to predict that more dynamism of challenger or neobanks could end their dominance. And challenger banks have doubtless upped the stakes, especially in customer service and with product innovations such as Buy Now, Pay Later (BNPL). But the premise that they are displacing traditional banks in the US and Europe is unproven.

So, what about the GCC?

With fintech valuations still high, the likelihood of traditional banks acquiring their upstart rivals is questionable. And venture capital, the main source of funding for many fintechs, is also under pressure. Data from PitchBook shows a downward shift in investor sentiment that might slow further funding rounds. Global deal activity fell to $350 billion last year, from $530 billion in 2022.

In the GCC, a digitally savvy population’s strong focus on user experience has helped neobanks disrupt the status quo for their traditional rivals. Fintechs in the region have benefited not only from innovative technology but from targeting a specific market segment, says Michael Ashley Schulman, partner and CIO at Running Point Capital Advisors.

That leadership could prove temporary, however, and may be just as likely to benefit traditional banks.

“GenAI can quickly make traditional banks more efficient and effective,” says Schulman. “It may threaten challenger banks by eroding competitive advantage more than it helps them; neobanks have been known for innovation for more than a decade, but the digital gap has narrowed and their frontrunner status may slip faster with generative AI.”

So, is that goodbye to further growth for neobanks? Not quite.

Some analysts, including Schulman, speculate the rivals could find a compromise that results in more collaboration. “An uptick in mergers and exploratory partnerships seems inevitable,” he predicts.

In the US and Europe, challenger banks have lost some of their luster with the realization that banking is built on relationships and that retaining customer loyalty necessitates a presence across multiple—often unexciting—business clusters.

Setting the GCC apart is its importance as a center for Islamic finance, a market with assets of $4.5 trillion in 2022, according to November’s ICD-LSEG Islamic Finance Development report, the latest date for which figures are available. Bahrain and Dubai are positioning themselves as Islamic finance hubs, and applying generative AI would seem a natural progression that could have global implications for the two tech-centered economies.

One advantage: Falling costs of training could also move Islamic finance toward a wider adoption of GenAI. And while the interpretative characteristics of sharia law make adapting AI to Islamic finance a complex task, AI-driven applications and processes that offer opinions on financial products’ and transactions’ validity and adherence to Islamic finance law could further the GCC’s ambitions as a go-to hub.

That said, the need to address cultural and legal issues could hamper development of a dedicated AI tool, warns Yiannis Antoniou, practice head of Data, Analytics, and AI at consultant Lab49.

“The lack of a cohesive and widely accepted cross-border Islamic finance framework leads to complexity and inefficiencies that make multinational financial institutions’ compliance [obligations] especially difficult,” he says.

Automating work and deriving cost savings are just the beginning of what could be an extraordinary chapter in GCC banking. Yet, the real opportunity lies in harnessing generative AI to fuel growth—assuming the latest innovations do not overwhelm banks and result in a loss of control.

“Banks won’t be able to cordon off generative AI’s impact on their organization in the early days of change,” Accenture’s AI in banking report states. “It touches almost every job in banking.”

Still, with substantial financial resources and a falling cost of training personnel in AI, banks in the GCC have an opportunity to overtake the successes of their maverick fintech rivals.

Another year, another bumper crop of profits. Banks in the six-member Gulf Cooperation Council (GCC) are set to reap further gains as higher oil prices, increased public-sector spending, and red-hot real estate markets combine to generate a heady lending environment. In the first quarter of this year, the combined profits of 57 listed banks jumped 10.5% to $14.4 billion compared to the same period in 2023, Kuwait-headquartered Kamco Invest said in a May report.

Quarterly performance was similarly robust, with an 11.8% surge in quarter-on-quarter profits.

But there are headwinds, including an expected change in monetary policy by the US Federal Reserve, mounting competition, and geopolitical uncertainty.

Meanwhile, banks in Saudi Arabia and the United Arab Emirates may face liquidity challenges as they scramble to meet strong lending demand driven by governments jockeying to liberalize their economies. That scenario could trigger renewed consolidation, some analysts predict, as GCC banks, with limited regional options, look to other jurisdictions to achieve operating efficiencies and cost savings.

GCC banks have been riffing off the Fed’s last monetary tightening cycle to support earnings; higher interest rates typically boost loan yields and fee income. At the end of 2023, the average return on assets of the region’s top 45 banks reached 1.7%, up from 1.2% at year-end 2021, according to ratings agency S&P Global.

With the exception of Kuwait, where the dinar is pegged to a basket of currencies, GCC governments peg theirs to the US dollar, and so they typically follow US interest rate changes to preserve their pegs.

Yet, a Fed move to lower may pressure some GCC banks. S&P estimates that every 100-basis-point rate drop corresponds to around a 9% reduction in bottom-line profits. The most vulnerable bank S&P rates may see as much as a 30% drop in the bottom line for every 100 basis point cut.

Despite the chances of an erosion in earnings, however, merger and acquisition activity among GCC banks has gone quiet since it reached a pre-pandemic peak in 2019 when 11 deals worth $118 billion were consummated, according to data from PitchBook. Last year saw few blockbuster deals, adding to speculation that a fresh burst of activity might be overdue.

While it is unclear when the Fed will begin reducing interest rates and by how much, when it happens, the shift could alter GCC banks’ risk profile. The good news is that rate cuts would reduce the number of unrealized losses that institutions in the region have built up amid frenetic lending. These might be as much as some $2.8 billion for rated GCC banks, or 1.9% on average of their total equity at year-end 2023, S&P estimates.

Still, lower profits are not the only consideration for banks when they weigh M&A to achieve cost efficiencies. In recent years, deals among the larger banks have been a shortcut to building market share. But it is widely acknowledged there are too many banks in local banking markets at a time of mounting competition from smaller, more agile rivals.

“Consolidation makes sense for overbanked systems in the region,” says Mohamed Damak, managing director, sector lead financial institutions, Middle East and Africa at S&P Global Ratings. “It can be even more appealing in an environment where interest rates and profitability are reducing.”

Regional banks’ appetite for international acquisitions that diversify them away from their home markets will drive M&A activity. “By deploying capital into high-growth markets, they may be able to compensate for weaker growth opportunities in their home markets,” Fitch Ratings said in May. 

Increasing competition from swashbuckling fintechs could also spur M&A. Challenger banks and neobanks have gnawed away at conventional banks’ market share and are a preoccupation of C-suite executives. Their continuing impact on profits may also spark consolidation, analysts suggest.

Fintech valuations, by contrast, are high, and that may limit outright acquisitions by conventional banks looking to take their rivals’ innovations in-house. Not all banks will be able to compete in the new environment, and governments will be mindful of any threat to systemic stability, says Hiba Chamas, business development director, Americas and MENA, at RTGS.global, a London-based cross-border settlements fintech.

“Regulatory pressures may play a significant role, with authorities mandating mergers to reduce the number of smaller, weaker banks and enhance financial stability in the region,” says Chamas. Smaller banks that lack capital to invest in fintech or build their own products may be compelled to merge with larger institutions, she suggests.

Some of the GCC’s larger banks have already bought into corporate marriages as a way to diffuse geopolitical risk and an overweight dependency on oil-related revenue. The UAE triggered an earlier flurry of M&A activity in 2016 when First Abu Dhabi Bank emerged from the union of National Bank of Abu Dhabi and First Gulf Bank, spurred by a desire to leverage scale and deliver cost synergies.

That deal was followed in 2019 by the tripartite merger of Abu Dhabi Commercial Bank, Union National Bank, and Al-Hilal Bank. Other notable GCC deals have included the creation of Saudi National Bank in 2021 through the merger of National Commercial Bank and Samba Financial Group, creating Saudi Arabia’s largest bank. Smaller deals have taken place in Bahrain, Kuwait, Oman and Qatar.

Today, several GCC banks are reportedly looking to acquire financial institutions outside of their domestic markets. But snapping up banks in lower rated jurisdictions could be problematic, warns Fitch Ratings. GCC banks already have substantial exposures in countries such as Turkey and Egypt, and further international expansion would come with uncertainties regarding foreign exchange and interest rate risk, according to Fitch.

Burgan Bank (Kuwait), Emirates NBD (UAE), Qatar National Bank and The Commercial Bank (Qatar) have all seen changes to their rating profiles as a result of exposure to Turkey. Qatar National Bank’s additional exposure in Egypt’s weak economy also makes it vulnerable to changes in the local macroeconomic environment. And Kuwait Finance House has a higher exposure to Turkey and Bahrain, Fitch notes.

Cross-border M&A within the GCC is complicated, too, given large government shareholders in some of the region’s major banks. Strong balance sheets and solid project pipelines reduce the likelihood of consolidation in the GCC, says Junaid Ansari, director of investment strategy and research at Kamco Invest, which could make deals outside the region more attractive. “Consolidation within the region would only be limited to the ongoing deals, but we expect to see an increase in overseas M&A deals by GCC banks.”

Tight liquidity, meanwhile, is resulting in prolific levels of US dollar debt issuance by GCC banks to fund soaring credit demand. Fitch calculates that annual issuance in 2024 and 2025 could exceed the 2020 record of $25.2 billion. With government initiatives including Saudi Arabia’s Vision 2030 and Dubai’s D33, which entail mind-numbing levels of spending, banks’ loose change for M&A might be constrained.

The GCC is also no stranger to Black Swan situations, and a sudden shock event might be enough to force or scupper M&A deals, dealing a blow to business confidence. Of primary concern would be a widening of the Israel-Hamas war or an escalation of attacks by Yemen’s Houthi rebels in the Red Sea. Especially if Iran is drawn into the conflict, the economic impact would be dramatic and possibly lead to a spike in non-performing loans.

“Were the scope of the Israel-Hamas war to widen significantly,” Fitch said in January, “Middle Eastern countries could be affected by further disruption to oil trade routes, or, potentially, production capabilities, and could also experience a marked negative impact on non-oil activity.” That would likely set back their plans for longer-term economic diversification, although higher oil prices could provide an offset.

As the GCC’s second-largest economy, the UAE looks particularly exposed. In 2020, it was a signatory to the Abraham Accords, normalizing relations with Israel. The emirates are now reportedly Israel’s second-largest trading partner in the Middle East, yet it is unclear what level of exposure UAE banks have to nascent bilateral trade.

These concerns are another reason some observers argue that the best bet for GCC banks, bolstered by their healthy balance sheets, is to diversify into markets outside the region, lowering risk and lessening their dependency on hydrocarbon-related income in a region known for springing surprises. 

The Omani government is planning a levy ranging from 5% to 9%, but its application to citizens and expatriates will be different. Omani citizens will be taxed at a flat rate of 5% on their net global income above $1 million. Expatriates pay a tax on incomes exceeding $100,000, a move that is likely to be closely scrutinized by other Gulf states.

While Oman’s initiative could nudge other GCC countries toward similar reforms, immediate adoption seems unlikely, says Mazen Salhab, chief market strategist—MENA at BDSwiss. Saudi Arabia and the United Arab Emirates have indicated they have no plans to introduce income taxes. And Oman, for its part, “may face challenges in competing with its tax-free neighbors for skilled expatriates and international businesses.”

The logic behind the sultanate’s move is clear, however. Along with Bahrain, Oman’s economy has strained under the weight of a heavy debt burden that saw the ratio of public debt to GDP reach almost 70% at its peak in 2020. Austerity implemented under Sultan Haitham bin Tariq Al Said, Oman’s head of state, has since pushed it back to around 35%, according to London-based Capital Economics.

Earlier reforms aimed at tightening fiscal policy included the introduction of a 5% value-added tax in 2021, but the optics surrounding an income tax are likely to ripple through the GCC expatriate workforce. And its expected impact on Oman’s budget—adding just 0.2% to GDP by 2026, according to Fitch Ratings’ forecasts—is minimal. Still, an income tax would provide the government with an additional tool to diversify future revenue sources. The good news is that earlier cuts in government spending, combined with a determination to stabilize public debt, have had a dramatic effect on Oman’s budget position. From a deficit of nearly 20% of GDP in early 2021, it swung into a surplus of 2.5% last year, according to Capital Economics. 

In July, BYD—an acronym for “Build Your Dreams”— unveiled its new EV plant in Thailand, having reportedly investing $486 million to gain a foothold in what was until recently Southeast Asia’s second largest auto market. The plant, BYD’s first in Southeast Asia, has the capacity to produce 150,000 vehicles a year. BYD’s push into Southeast Asia was followed by a $1 billion investment in Turkey in a plant that can also produce 150,000 per year.

By choosing Turkey, BYD sidesteps punitive tariffs Brussels is about to levy on Chinese automakers. While not a member of the EU, Turkey enjoys a customs union with the bloc, which means BYD will be able to reexport vehicles to the EU without incurring a 27.4% tariff currently under discussion.

Tariffs and restrictive regulations are forcing Chinese automakers to reconsider their game plan, says Richard Lawton, head of marketing and communications at DriveElectric, an EV leasing and carbon management company.

“It’s likely that these tariff increases might influence the future decision-making processes of BYD as well as other Chinese manufacturers, especially when it comes to making strategic investments,” he notes.

BYD, in which Warren Buffett’s Berkshire Hathaway holds a 6.9% stake, also has Elon Musk in its crosshairs; it is set to surpass the Tesla in battery EV sales this year, research firm Counterpoint said in a July report. Chinese automakers are turning their attention as well to emerging markets in the Middle East and Africa, Latin America, Southeast Asia, Australia, and New Zealand, Counterpoint notes.

With US and European automakers struggling to compete, much will hinge on high-level trade talks. “The outcome of EU-China talks, especially with Germany’s opposition, will shape future EV market dynamics, with Europe [and] the US driving growth from 2025 onwards,” Counterpoint said in a statement. Elsewhere, BYD has its sights set on Indonesia, Southeast Asia’s largest auto market, having forged an alliance with domestically based Neta Auto to build a $1 billion factory set to become operational by 2026.      

Government debt has mushroomed in recent years, hitting 15.3 trillion pesos—around $264 billion in May—according to Bureau of the Treasury estimates. Manila reportedly plans to borrow a further $3 billion this year as part of a $5 billion bond program that began in May. The country’s debt-to-GDP ratio is currently in excess of 60%, the Treasury says.

The DoF recently held talks in Japan with Sumitomo Mitsui Banking Corporation and Nomura Securities as part of a roadshow to gauge interest from investors there. The final timing for the new bond issue is likely to be linked to the US Federal Reserve’s decision later this year on lowering interest rates.

The government has tapped Japanese bond markets before.

In 2018, the publicly held Japan Bank for International Cooperation acquired part of a multi-tranche ¥154.2 billion (roughly $1.39 billion) samurai bond offering by the Philippine government, data from the Treasury shows. The following year, it raised ¥92 billion (approximately $860 million) of samurai bonds in a three-tranche offering. And in 2021, it raised ¥55 billion in three-year, zero-coupon samurai bonds: its first-ever zero-coupon Japanese offering, which saw strong interest from investors.

But Manila’s latest return to the well has a larger political context. In early July, the Philippines inked a defense pact with Japan amid tensions with China over disputed territory in the South China Sea: further evidence that trade and finance have become intertwined with regional geopolitics.  President Ferdinand Marcos Jr.’s government is also courting investors to sustainably develop its nickel reserves to meet demand for the metal’s use in electric vehicle batteries. After Indonesia, the Philippines is world’s second largest producer of the metal, according to Statista. 

In total, Dubai pulled in 1,650 FDI projects in 2023, amounting to just over 39 billion dirhams, or around $10.7 billion, an increase of 39% over the previous year’s figure. It also ranked first globally for greenfield FDI in several key sectors, including consumer goods, energy, e-commerce, and tourism.

Greenfield FDI refers to either from-the-ground-up business or expansion of existing business initiated by companies based abroad. Dubai’s pole position in the rankings is noteworthy given Saudi Arabia’s increasing efforts to entice multinationals to establish or headquarter operations in the kingdom. Riyadh is pushing ahead with plans, including its Vision 2030 initiative, to reduce its dependency on hydrocarbon revenue.

Dubai has defied predictions of corporate atrophy despite pressure from Riyadh on multinationals, analysts say. While Saudi Arabia is the region’s largest economy, 60 companies chose Dubai for their headquarters last year. It also has seen its share of global greenfield projects triple to 6%, WAM stated.

But Dubai’s competitive offering could be tested by schemes such as Saudi Arabia’s Project HQ, which aims to persuade multinationals to establish a permanent presence in the kingdom.

“This initiative might present challenges for Dubai, given the significant value of Saudi’s government contracts,” says Vijay Valecha, CIO of Century Financial in Dubai.

Even so, the emirate has a history of rising above such challenges to maintain a competitive advantage. Companies are also drawn by its robust legal and regulatory environment, which are often aligned with global best practices. Dubai’s determination to maintain its position as a go-to investment destination in the Middle East shows no signs of abating. Under a government-backed initiative known as D33 has committed to doubling the size of its economy in the next decade to just under $9 trillion to become one of the top three global cities

Belgium, which is often referenced as a proxy custodian for China’s debt holdings, reportedly disposed of more than $20 billion of Treasuries in the same period.

Not everyone is convinced China’s US debt sales represent anything aggressive as opposed to a routine realignment of debt management activities by the world’s second largest economy. But the question whether Beijing is dumping US debt, combined with a potential broader adoption of the renminbi, suggests the US government will need a strategy to manage the impact on perceptions of the greenback as the world’s reserve currency.

 “The core issue of whether China has diversified at the margin out of the dollar/dollar bonds or has diversified its set of custodians beyond the US custodians and Euroclear remains unresolved,” Brad Setser, senior fellow at the Council on Foreign Relations, wrote on X, formerly known as Twitter, last month.

But that doesn’t mean Beijing’s pattern of rotating out of US debt into commodities such as gold is insignificant, analysts say, indicating a desire to mitigate risk amid the threat of US sanctions on China over trade with Russia. Punitive tariffs imposed by the Biden administration may also be fueling Beijing’s ambitions to diversify its holdings. In the first quarter, China’s gold reserves rose by 27.06 tons, second only to Turkey’s, according to the World Gold Council.

Meanwhile, the recently expanded BRICS trade bloc, in which China plays an influential role, has expressed unease over the macroeconomic dominance of the dollar and is seeking alternative reserve currency choices. This might accelerate China’s ambitions to internationalize the renminbi and offer a geopolitical solution for the nascent trade bloc—although not all BRICS constituents agree.

Sanctions related to restrictions have prompted use of the United Arab Emirates’ dirham in India-Russia trade, bolstered by “Indian officials’ discomfort with use of the renminbi by Indian importers,” the Carnegie Endowment for International Peace said in a December report on BRICS de-dollarization efforts.

Lee had earlier indicated that the 51-year-old Wong would take over on the symbolically loaded date of November 21, the 70th anniversary of the founding of the ruling People’s Action Party (PAP).

As party leader of the PAP, which attracted one of its lowest shares of votes in Singapore’s history in the 2020 elections, Wong will face a daunting set of challenges.

He must quickly restore public confidence in the party ahead of a general election scheduled for November 2025, but which may take place much earlier. And he must grapple with the simmering rift between two of its top trading partners, the US and China.

That conflict is reflected in domestic political differences as well. Rahman Yaacob, a research fellow in the Southeast Asia Program at the Sydney-based Lowy Institute, said in a recent analysis, “There is a divergent perception of China and the United States between Singaporean elites and the general population.”

The island city-state has pursued a policy of neutrality but faces pressure from fellow ASEAN countries unhappy with Beijing’s increasingly assertive claims in the South China Sea. As outgoing chair of the Monetary Authority of Singapore, Wong will also be mindful that inflation is crimping consumers’ spending power and could foment popular unease over PAP policies.

Advance estimates of first-quarter GDP show growth falling sharply from 1.2% from the fourth quarter of last year to just 0.1%, according to London-based Capital Economics. Finding a way through these thickets will not be Wong’s job alone, however. Lee will stay on in the cabinet as senior minister, Wong stated last month.

Bahrain was once favored to be the leading financial center of the six-member Gulf Cooperation Council (GCC). Dubai has since seized the title, and other jurisdictions in the region—including Abu Dhabi, Qatar, and most recently Saudi Arabia—have all launched initiatives to become financial hubs.

Questions about Bahrain’s dependence on hydrocarbon revenue, the pace of economic diversification, debt levels, and its place in the GCC’s geopolitical matrix continue to thwart the island kingdom’s ambitions.

Still, earlier this year, Bahrain was ranked No. 1 globally for Islamic finance regulation in the ICD-LSEG Islamic Finance Development Report. Efforts to attract foreign direct investment are also progressing. In 2022, the latest period for which data is available, FDI inflows reached $2.76 billion, a 55.2% increase over the previous year, according to the Bahrain Economic Development Board claims.

Retaining institutional confidence is a priority for policymakers. In February, Bahrain’s government tapped bond markets to meet looming debt repayments, issuing a seven-year sukuk—an Islamic financial instrument compliant with Shariah principles—and a 12-year conventional bond, each worth around $1 billion, taking advantage of lower US Treasury yields and narrower spreads.

Investors have bought into Bahrain’s story, at least for now, says Franck Bekaert, an emerging markets analyst at Gimme Credit. “The spreads of Bahrain bonds are already very tight, and the Middle East’s geopolitical tensions are still ongoing,” he notes.

Last year, Bahrain’s budget deficit stood at only about 2.5% of GDP, but the gap is expected to widen this year, London-based Capital Economics warned in a February note. Around $2 billion in Eurobond principal repayments fall due in 2024, and a more onerous repayment schedule looms in the following years. At its peak, Bahrain’s debt-to-GDP stood at 100.5%. Although it has since fallen to 89%, it remains a hefty burden.

Implicit in retaining investor confidence is the kingdom’s ability to call upon other Gulf states, notably neighboring Saudi Arabia, for financial support, suggesting that the risk of sovereign default remains low, Capital Economics says. Some analysts are hopeful Bahrain will continue to liberalize its economy and finally secure its position as a key GCC economy, but the emerging consensus is that further reforms are needed.

Despite not being a member of OPEC+, Bahrain shadows the cartel’s policy. Oil accounts for more than 70% of Bahrain’s government revenue, according to the US Department of Commerce, and planned output cuts will weigh on the country’s growth prospects this year, including in the non-oil sector. Even so, with GDP projected to increase around 3% year-on-year, Bahrain is tied with the United Arab Emirates (UAE) as having the strongest growth prospects in the GCC, Capital Economics estimates.

Oil’s existentially important contribution to Bahrain’s economy underlies the government’s plans to double down on investment. While the UAE recently hosted COP28, which underlined global concerns with the impact of fossil fuels on climate, Bahrain, with US support, aims to dramatically expand oil and gas production.

The US Export-Import Bank is backing Bahraini proposals to drill more than 450 new oil and gas wells as part of a $4.2 billion program to boost production following the discovery of new reserves in 2018. Pumping oil and gas from the enlarged field is forecast to belch out more than 1.4 million tons of CO2 a year by 2026, double the level of 2022.

Nascent attempts to diversify the economy have yielded mixed results, leaving the kingdom little choice but to increase capacity. Still, the government remains mindful of its environmental obligations, says Ujjwal Deb, vice president of Energy and Commodities at Publicis Sapient. “They need to drill for more oil and increase their refining capacity by two-thirds,” he estimates, “which they are planning to do in conjunction with carbon-capture tech to avoid breaching their 2060 net-zero goals.”

Bahrain nonetheless remains attractive to investors. Manufacturing accounted for 17% of FDI in 2022. And in January, Conexus Resources Group, a UK company active in metals and agricultural commodities, inaugurated a $100 million, 32,000-metric-ton-capacity aluminum plant.

The government is also hoping that an early embrace of cloud technology, which saw Bahrain adopt a national “cloud first” policy in 2017, will reap dividends over the next few years. A report by International Data Corporation predicts cloud spending will contribute over $1.2 billion to the kingdom’s GDP by 2026, roughly equivalent to 23% of total GDP. Already in 2019, Amazon Web Services chose Bahrain to host the first AWS Region in the Middle East and North Africa. China’s Huawei has its Middle East and Central Asia headquarters on the island, as well.

Bahraini companies, meanwhile, are accelerating plans to increase offshore investments. Investcorp, a Bahrain-based alternative asset manager, is raising between 2 billion and 4 billion yuan (around $274 million to $548 million) for its first-ever private equity fund in the Chinese currency. Investcorp’s CEO said in November that the firm intends to apply for a license from Chinese authorities to begin raising funds from domestic institutions.

Ambitions to grow the economy prioritize nurturing non-oil sectors such as tourism, financial services, manufacturing, transport and logistics. Together with plans to develop innovation and entrepreneurship, they form the bedrock of Bahrain’s venture-capital ecosystem. Mumtalakat, the kingdom’s sovereign wealth fund with some $18 billion in assets, is leading these efforts, investing in companies and sectors aligned with the government’s diversification goals, notes Michael Ashley Schulman, partner and CIO at Running Point Capital Advisors.

Bahrain is also keen to tap rising trade flows between the Middle East and China. Tourism looks set for a boost, with the announcement of direct flights between Bahrain, Guangzhou and Shanghai. And the GCC is hoping to seal a free-trade deal with China that would potentially expand bilateral trade. Aside from China’s capacious demand for oil, Beijing has highlighted the GCC’s allure for inclusion in President Xi Jinping’s Belt and Road Initiative.

Despite limited results thus far, Bahrain is betting big on diversifying its economy. The government is now executing a multiyear economic plan that aims to attract over $30 billion in strategic investments to enhance non-oil growth, notes Schulman, who expects a tilt toward investments as opposed to direct government aid, which is hampered by debt obligations.

The Fiscal Balance Program (FBP), designed to reduce government expenses and achieve fiscal balance, “has bolstered fiscal policymaking, though fiscal flexibility remains constrained due to high debt levels and reliance on oil revenue,” Schulman says.

The updated FBP includes a statement of support from Bahrain’s GCC partners, who note that the GCC development fund will continue to undertake capital expenditure projects in Bahrain, Fitch Ratings said in August. Even so, Schulman argues the government will have to reduce layers of bureaucracy—intrinsic in a government appointed by the king—to achieve its goals.

“Centralized decision-making can impact support for sustainable public finances and balanced economic growth,” he says.

Equally crucial is simplifying regulations and procedures in order to create a dynamic business environment that attracts and retains international companies, says Yusuf Mansawala, chief market analyst at CPT Markets. But Bahrain must also upskill its workforce.

“Investing in the development of human capital is essential to equip its citizens with the expertise needed to compete in the global market,” Mansawala says.

Bahrain’s location at a strategic crossroads is both a blessing and a curse to its investment and development aspirations. China’s interest in the Gulf region is quasi-political, including a need to keep oil flowing. The Strait of Hormuz is a vital conduit for Bahrain’s oil exports, but the recent rise in tensions as a result of the conflict between Israel and Hamas and the Houthi attacks on shipping has brought the region to the brink. In 2020, Bahrain and the UAE were the only GCC members to agree to normalize relations with Israel in what became known as the Abraham Accords.

Last year, Israel opened an embassy in Manama. But unlike the UAE, Bahrain has seen little economic benefit from the rapprochement. As home to the US Fifth Fleet, a defensive backstop against Iran’s regional ambitions, Bahrain walks a political tightrope.

The kingdom also needs to reassure investors of its long-term viability. While it has avoided major unrest, protests over Israel’s policy in Gaza have spilled over into the streets. Prior to the latest conflict, the World Bank awarded Bahrain only a 30.66 percentile rank for political stability in its 2022 Worldwide Governance Indicators (a score of 100 corresponds to the highest rank).

When Japan unexpectedly entered a technical recession last month, industrial behemoth Germany became the world’s third largest economy. Japanese GDP contracted by 0.4% in the last quarter of 2023, compared to 2022, triggering a reordering of the leading economices.

But Germany is facing its own set of problems, many of them structural.

Dogged by inflation and high energy costs, it narrowly avoided recession at the end of 2023 as its economy shrank 0.3%. Growth is forecast to remain weak this year at best; the government has revised down its forecast GDP growth from 1.3% to just 0.2% and Capital Economics of London predicts the economy will not grow at all in 2024.

As the eurozone’s largest economy, Germany is widely considered the bloc’s barometer. High interest rates and weak demand are bearing down on the EU, impacting business sentiment. Expectations that the European Central Bank  might cut record-high interest rates were scuppered last month after the bank said it was too early to do so.

Policymakers’ fixation on reining in eurozone inflation and refusal to cut rates might be enough to tip Germany into a full-blown recession. Supply-chain disruption could intensify in the short-term, too, amid continuing attacks on Red Sea maritime traffic by the Houthis, creating more uncertainty for Germany’s export-led economy.

Unsurprisingly, bearish sentiment is on the increase.

Last month, Robert Habeck, vice chancellor and minister for Economic Affairs and Climate Action, went so far as to describe the situation as “dramatically bad.” In a recent note, ING noted numerous concerns. “To make things worse,” the Dutch bank said, “the new year brought new problems for the German economy: strikes by train drivers and supply chain disruptions as a result of the military conflict in the Red Sea have made another contraction in the German economy in the first quarter of the year even more likely.”