Bahrain Mirror- Reuters: Bahrain may need to raise its market interest rates to protect its currency and must refrain from having its central bank lend money to cover the government's budget deficit, the International Monetary Fund said on Monday.

In a statement released after annual consultations with the Bahraini government, the IMF repeated earlier warnings that more steps by Bahrain to cut its deficit were "urgently needed" to stabilize state finances and support the Bahraini dinar's BHD= peg to the U.S. dollar.

It then went further, saying: "Gradually raising interest rate differentials vis-a-vis the United States through the stepped-up issuance of government securities could also help discourage capital outflows and rebuild reserves."

The spread of Bahrain's three-month interbank offered rate MBHD3MD= over the U.S. dollar London interbank offered rate USD3MFSR=X has already expanded to 113 basis points from 74 bps since the end of 2014. The IMF did not say how wide the spread might need to become.

"Directors also stressed the importance of discontinuing central bank lending to the government," the IMF added. It did not give details of the central bank's loans to the government; such lending is considered unsound policy by many economists because it can fuel inflation and undermine the currency.

Bahrain lacks the ample financial and oil reserves of its neighbors and has been hit harder than them by a reduction in its export revenues due to slumping oil prices, although it is a close ally of Saudi Arabia, which might aid it in any crisis.

Last month, Moody's Investors Service downgraded Bahrain's credit rating by two notches to B1, four notches below investment grade. All three major rating agencies assess Bahraini debt as junk.

In June, Bahrain's cabinet approved a draft budget for 2017 and 2018 that projected only slow progress in cutting the budget deficit. The draft was delayed for several months by the difficulty of balancing fiscal reforms with political pressure for welfare spending and the need to invest in economic growth.

The IMF's statement projected Bahrain would run an overall fiscal deficit, including off-budget spending, of 12.2 percent of gross domestic product this year, compared with a deficit of 17.8 percent last year.

It predicted Bahrain's gross official, external reserves would stay flat at $2.4 billion, down from $6.1 billion in 2014 and equivalent to only 1.4 months of imports of goods and services.  

Arabic version